THE INVESTMENT CASE
The primary investment case for high-yield bonds is higher income, which contributes to higher total returns. High-yield bonds are also less sensitive to changes in prevailing interest rates. For this reason, they tend to be less correlated to other asset classes (meaning they don’t always move in lockstep with equities or investment-grade government or corporate bonds). As a result, they act as a diversifier within a multi-asset portfolio.
High-yield bonds are defined by their credit rating. There are several global ratings agencies, such as Moody’s, Fitch and S&P, and high-yield bonds are those with a rating below what they consider investment grade. The lower rating reflects a higher risk associated with defaulting on the loan, or not paying the interest, and means that high-yield bonds are also more volatile than investment-grade bonds.
But a lower credit rating can also indicate that an issuer is a start-up company on the rise, or has been temporarily downgraded after a bad quarter. Many major corporations at one point have had their bonds moved into the high-yield category. Consequently, high-yield bonds are often referred to as falling into one of two categories: “fallen angels” (those whose credit quality has fallen on hard times) and “rising stars” (new issuers who are moving upwards in credit quality).
Investing in a high-yield bond fund (rather than in individual issuers) can mitigate default risk substantially, while offering additional yield.
HOW GLOBAL HIGH YIELD FARED DURING THE RECENT MARKET TURMOIL
At the height of the coronavirus-related market declines, investors fled from riskier assets, which included equities and high-yield bonds. Higher-rated bonds, including government bonds, had better returns, although many of these, too, recorded losses. In addition to market returns, the corporate bond market suffered a period of poor liquidity that threatened to derail the asset class further. However, as the world’s governments and central banks stepped in to implement relief measures, the liquidity squeeze was lessened. The Bank of England and the US Federal Reserve, for instance, started asset purchase programmes that involved buying corporate bonds in a bid to restart the market (the first time in history that this has ever happened). While most of these bond purchases were investment grade, some high-yield issuance was included and overall the trading improved for bonds as a whole. Further, the appetite for higher-risk assets has picked up, and the need for better yield has gained momentum in an ever-lower interest rate environment.
OUTLOOK FOR HIGH-YIELD BONDS
The divergent performance of investment-grade and high-yield bonds during the market falls in March underscored the role of high yield as a diversifier in a multi-asset portfolio. Diversification refers not just to a split between equities and bonds, but diversifying within the bond component across a range of ratings, rates, and regions. As economies begin to re-open and signs of a recovery emerge, the long-term opportunities in the high-yield space are compelling.