The lure of double-digit annual bond yields has investors heading to high-yield bonds at a time when negative interest rates and inverted yield curves are the main themes in the fixed-income market. But investors should remember there’s a good reason high-yield bonds are also called junk bonds, experts say.
In the first three quarters of 2019, a higher-than-average US$222-billion in high-yield bonds have been issued by corporations providing rich rewards for those willing to take the risk that comes with taking on debt that has a lower credit rating.
“Returns to date have been over 11 per cent in the junk bond market. That’s why people are buying them. They like the returns,” says Hank Cunningham, a veteran bond trader and fixed-income strategist at Odlum Brown Ltd. in Toronto.
But income-hungry investors who chase the highest yields blindly face an unusually high risk of default as signs of a faltering economy persist, he warns.
“[The high-yield space is] fraught with danger,” Mr. Cunningham says. “The bond market is forecasting a recession. In a recession, high-yield bonds would not do so well. The default rate would rise and you would face poorer returns in the high-yield market.”
He points to the recent inversion of the bond yield curve, which occurs when yields on 10-year U.S. treasuries fall below shorter-term treasuries, as as sign of a coming recession. In normal times, longer-term bonds have higher yields to compensate the lender for committing to a longer term.
“Right now, I’m not recommending high-yield [bonds] because of the recessionary concerns I have,” Mr. Cunningham says.
Junk bond yields may appear to be high, but they’re not compensating investors properly for the current degree of risk they’re taking on compared with safer investment-grade bonds, he says. The difference, or the spread, is only 4 percentage points on average – and it’s normally wider.
Although the time might not be right for junk bonds, Mr. Cunningham says higher interest rates and wider spreads in the future could make them a good purchase for investors who want to mix them with safer, lower-yielding fixed-income securities in a diversified portfolio.
“There’s a role for high-yield [bonds] in a fixed-income portfolio – and my rule-of-thumb is a maximum of 10 per cent,” he says.
Even when better days come for high-yield bonds, Mr. Cunningham advises investors to avoid the risk of buying individual junk bonds and invest instead in an exchange-traded fund (ETF) that holds a wide variety of high-yield bonds, such as iShares iBoxx $ High Yield Corporate Bond ETF (HYG-A).
This U.S.-listed ETF “has 959 holdings. ... Your chance of a major loss is minimized by the breadth of the holdings, not only the number of holdings but it crosses all the sectors in the U.S. economy,” he says.
The ETF currently yields 5.3 per cent and has gained in value by more than 11 per cent so far this year. The management expense ratio (MER) is 0.49 per cent.
The Canadian dollar-hedged version of the ETF, iShares U.S. High Yield Bond Index ETF (XHY-T), has an MER of 0.67, which is reflected in a slightly lower return.
“You have to have your own view of the currency. If you don’t want the currency risk and just want your return in Canadian dollars, then you choose the hedged version,” Mr. Cunningham says.
Joey Mack, director, fixed-income, at GMP Securities L.P. in Toronto, agrees that investors who are being drawn in by junk bonds’ higher yields could live to regret their decision.
“Chasing yield only, without considering everything else, is usually a bad strategy,” he says. “It’s a pretty simple correlation: The higher the yield, the higher the default risk.”
Mr. Mack says high-yield bonds are much more sensitive to the economy than investment-grade bonds because junk bond issuers’ earnings are impacted more acutely by the economic environment.
“When the central banks are cutting [interest] rates, they see economic clouds on the horizon, and that’s generally not a good environment for high-yield bonds,” Mr. Mack says.
Investors looking for a better mix of yield and security should consider higher-rated BB corporate bonds, which pay an average of 3 per cent annually for five- to 10-year terms, he says.
“In this environment, you want to err more toward the better quality within high-yield. That’s the BB space – just a notch below investment-grade. They tend to weather the storm better when you’re facing a recession” Mr. Mack says.
However, he says BB-rated bonds carry a risk more consistent with equities – and retail investors should not consider them part of the fixed-income component of their portfolios.
“What’s important to know in your portfolio is that high-yield’s performance is linked much more closely to equities markets’ performance than it is to the bond market. If you have a big downturn in equities, your high-yield bonds are going to turn down, too,” he says.
For investors who rely on fixed-income – perhaps in retirement – there’s another key difference between high-yield and investment-grade bonds: High-yield bonds trade more actively during their terms, like stocks, while investment-grade bonds are often held to maturity, making them more consistent with the term “fixed-income.”
“Two things generally happen to high-yield bonds; they default or they get called,” Mr. Mack says. “You never really hold them to maturity.”