High yield bonds
High-yield bonds, also known as Junk bonds, are bonds that carry a low credit rating.[1][2] They are generally off limits for institutional investors because of their higher risk of default.[2] Hence they are also known as non-investment grade bonds. Non-investment grade bonds are rated[3] BB or lower (D means default); investment-grade bonds are BBB or higher, with AAAs at top, a status that government bonds in developed countries strive to attain or maintain.
High-yield bonds represent a small portion of fixed income markets (e.g., 7% of the U.S. taxable bond market).[4]
History
Historically, most high-yield bonds were originally investment-grade bonds which were downgraded to junk status. These emitters are known as "fallen angels".[2][5]
High-yield bonds were infamously promoted as an asset class by Michael Milken[6] of Drexel Burnam Lambert[7] in the 1980s as a means to finance leveraged buyouts. Milken was later jailed on charges of insider trading; and Drexel later failed, after posting its first losses in its history.
Since the mid-1980s, rather than being fallen angels, the majority of junk bonds are immediately rated as such[8] for a variety of reasons, for example because they are growing companies issuing debt for the first time.[2]
Risks
Credit risk
High-yield bonds carry a lower rating because the issuing entity is considered to have a greater than average default risk – that is, there is a risk that it would not be able to pay its debts and be forced into bankruptcy.[2] Should bankruptcy occur, bondholders would probably receive significantly less than the face amount of the bonds. For the period 1978-1997, the default rate on US high-yield bonds ranged from 0.2% to 10.3%.[9] Among defaulting issues, the average recovery was about 40% of face value during this period.[9]
Call risk
Issuers typically call their bonds when the interest rate goes down. High yield bonds come with additional call risk. If the issuers' credit ratings improve, they can call the existing bonds and borrow money at a lower interest rate.[5] This type of call risk is not applicable to bonds with high ratings.
In 2012, over 90% of bonds in the Barclays U.S. Corporate High Yield Bond Index had a call feature.[2]
Canada versus US
Canadian bonds are rated by three bond rating agencies: DBRS, Moody's and Standard and Poor's, which bought the Canadian Bond Rating Service in 2000.
The Canadian market for high-yield bonds is comparatively small: as of December 2018, the FTSE TMX Canada High Yield Bond Index contained 43 issues with a total market value of 11 billion Canadian dollars.
In contrast, the US is the largest junk bond market in the world, worth about 1200 billion US dollars as of July 2018.[10]
Place in portfolios
High-yield bonds can add additional income but carry higher risks. Because of these risks, authors disagree on their use in a portfolio. In a Bogleheads topic[11], the different approaches of investment authors Richard Ferri and Larry Swedroe is discussed: Ferri thinks that high-yield bonds have a place in portfolio design but Swedroe disagrees. The poor performance of some Canadian high-yield bond funds in 2008 has been noted by Luukko.[12]
Arguments for
- The higher yield relative to investment-grade bonds: an average of 5% extra yield in the US during 1987-2012[2] (do not confuse this 5% extra yield with a 5% extra total return: defaults have to be accounted for)
- Diversification benefit according to R. Ferri and some other authors[13]
Argument against
- Bonds are supposed to be safe and provide ballast, but high-yield bonds are volatile[14]
- High-yield bonds can be correlated with equities, and go down in price along with equities during bear markets[14][4]
- They can be difficult to trade in a bear market[4]
- According a Vanguard study, adding high-yield bonds to a portfolio of investment-grade bonds and equities did "not significantly boost a portfolio's risk-adjusted returns" for the period 1986-2013, i.e. junk bonds are not actually good portfolio diversifiers[4]
- Very few of the active mutual funds, and none of the ETFs, managed to match or beat the U.S. Corporate High Yield Bond Index (over 5 years) due to factors such as liquidity costs and other expenses [2]
Implementation
Because of the higher risk of this asset class, investors who decide to include high-yield bonds in their portfolios should consider two different approaches:
- The amount of high-yield debt in the portfolio should be limited. Ferri[15] recommends that 20% of the total bond allocation be in high-yield debt.
- Investors unwilling or unable to analyze corporate debt structure should consider using a high-yield bond mutual fund or exchange-traded fund[5] for this asset class.
Filters to sort mutual fund performance can be obtained from Globefund and Morningstar. There is a Financial Wisdom Forum topic[16] discussing the Phillips, Hager, and North High-Yield Bond Fund, which has one of the best returns in this category. Unfortunately, that fund has now been closed to new investors and replaced for new investments by RBC High Yield Bond.[17]
References
- ^ Wikipedia, High-yield debt, viewed Feb. 18, 2009.
- ^ a b c d e f g h Phillips CB (2012) Worth the risk? The appeal and challenges of high-yield bonds, Vanguard Research, viewed December 30, 2018
- ^ DBRS, Long-Term Obligations | Ratings Scales, viewed November 27, 2012.
- ^ a b c d Vanguard Canada, Four things clients need to know about high-yield bonds, October 19, 2015, viewed December 29, 2018
- ^ a b c Raymond Kerzérho, Spotlight on high-yield bond ETFs, June 11, 2019, viewed January 11, 2020
- ^ Wikipedia, Michael Milken, viewed Feb. 18, 2009.
- ^ Wikipedia, Drexel Burnham Lambert, viewed Feb. 18, 2009.
- ^ Bernstein W (2001) Credit Risk: How Much? When? Efficient Frontier, viewed December 30, 2018
- ^ a b Altman EI (1998) The Anatomy of the High Yield Bond Market: After Two Decades of Activity-Implications for Europe. New York University, Center for Law and Business, Working Paper #CLB-98-021, viewed December 29, 2018.
- ^ Bloomberg, The Corporate Bond Market Is Getting Junkier, July 2018, viewed December 30, 2018
- ^ Bogleheads.org, Swedroe versus Ferri on Recommended Asset Classes, viewed Feb. 23, 2009.
- ^ Rudy Luukko, Tread carefully with junk bond funds, Feb. 21, 2009.
- ^ Canadian Couch Potato, High-Yield Bonds and Your Portfolio: Part 2, October 6, 2010, viewed December 24, 2018
- ^ a b Canadian Couch Potato, High-Yield Bonds and Your Portfolio: Part 1, October 4, 2010, viewed December 24, 2018
- ^ Ferri, Richard A., All About Asset Allocation, McGraw-Hill, 2006. Page 149.
- ^ Financial Wisdom Forum topic: "Phillips, Hager and North High-Yield Bond", viewed Feb. 21, 2009
- ^ RBC Global Asset Management, RBC Global Asset Management Inc. closes PH&N High Yield Bond Fund to New Investors, April 5, 2016, viewed February 27, 2017.
External links
- Bogleheads wiki: High-yield bonds
