Got High-Yield Bonds?

For the last 15 years, the US stock market has produced an annual return of 8.5% to investors. Over the same period of time, corporate bonds have produced an annual return of 7%, Treasury Bonds 5%, and Treasury Bills 1.5% with an average inflation rate of less than 2%. Within the corporate bonds sector, the AA-rated corporate bond produced over 6%, while the A, BBB, B, and CCC-rates bonds have given a return of 7, 11.34, 15, and 29 percent, respectively.

As the popular proverb says, “there is no free lunch.” Higher returns are always expected to come with higher risk.

Though, investors should not chase the highest historical returns as the CCC-rated bonds quite often default, but should design a well-diversified portfolio for the long haul.

For bond investors in particular, there are three main sources of systematic risk: interest rate risk, credit risk, and sector risk. In a way, investors need to “pick the right fight” in order to beat the market. For example, in the current near-zero US interest rate and global negative rates environment, the market expects the interest rates to rise in the future. Therefore, it is less likely that this is the time to take on interest rate risk by extending into longer-term bonds, as they are the most negatively affected in a rising market. On the other hand, short-term instruments suffer from low yields. T-bills has been yielding 20-30 basis points a year for the past few years.

The credit risk of the bond stems from the business cycle as the US economy has rebounded since the recession of 2008. This has been a unique time because the credit risk has been driven by the sector risk during the most recent period, as the stock market has been strongly correlating to oil and commodity prices. All three asset prices have just bounced off the February low. Meanwhile, the US stock market has produced around 9% and oil prices have increased over 60%.

High-yield, or lower-rated bonds have placed themselves in a strategic position where they are acting-like stocks. The reason why low credit rated bonds are “high-yield” bonds is that, together with the stockholders, the low-rated bondholders are the second to last to receive compensation in case of a financial distress. By design, high-yield bonds are the least volatile to changing interest rates, but also more sensitive to economic growth than other bonds.

Among a rising interest rate and recovering economy, the PIMCO high income fund (PHK) has produced a year-to-date return of 22%, compared with S&P 500’s 7%. Ironically, high-yield “bonds” have delivered better returns than stocks. Due to their unique characteristics, the high-yield bonds deserve a permanent space in everyone’s portfolio.

Disclaimers: The Income Portfolio of the Roland George Investments Program currently has high-yield bond holding. The view in this article only reflects that of the author, not of the Roland George Investments Program or Stetson University.

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