Seven myths behind high yield bonds

  • Interest rates may be at or close to record lows, but there are still opportunities within fixed income
  • High yield bonds currently offer an attractive level of income, with an active approach able to address investors’ traditional concerns
  • The asset class has grown significantly over the past twenty years, giving access to a wide variety of issuers across different geographies and sectors

Have you ever considered investing in high yield bonds? As their name suggests, high yield bonds sit at the higher risk, higher yielding end of fixed income, with the asset class having grown significantly over the past two decades.

While many investors value them for their higher yields and diversification benefits, there are still many myths around the asset class. In this piece, we have set out to debunk the seven most common myths around high yield bonds and explain how they might work for your portfolio.

Myth 1: bonds are no longer attractive

While there are trillions of dollars in negative yielding bonds, high yield bonds currently offer a yield to worst of around 5.7% in the US and 4% in Europe1, in line with levels in the US for the past three years and slightly higher in Europe. On a relative basis, high yield spreads – or the extra yield over government bonds – remain at elevated levels compared to the past three years, despite increased central bank support for the asset class.

Myth 2: the risk of default is too high

Investors in high yield bonds are compensated by higher coupons for taking additional default risk. However, many do not realise what the historic average default rate is for the asset class, standing at 4.36% for the US over the past twenty years, and 3.49% for Europe.2

Default rates do tend to rise significantly during periods of economic stress, such as the bursting of the dotcom bubble or the global financial crisis. While they have not risen to comparable levels following COVID-19, we do expect defaults rates to remain elevated around 3-4%, and this is a risk investors should consider carefully.

There will be some companies who have taken on too much debt to get themselves through 2020. Careful credit selection will be important in mitigating the risk of default amongst these companies, with a selective approach to high yield investing showing some success in guarding against defaults in the past. For example, the global high yield strategy’s flagship fund has experienced a total of nine defaults since 2002, compared to 1,067 for the BAML Global High Yield index.

Source: AXA IM / ICE BofAML as at 31/12/2019. The universe shown is the combination of the relevant portions of the ICE BofAML Global High Yield Bond Index (HW00) and ICE BofA 0-1 Year High Yield Index (H544). Defaults: 2002: Worldcom, 2008: MPU Offshore; 2009: Hayes Lemmerz, Charter (CCH Holdings), RH Donnelley; 2010: Penhall International Corp; 2012: Nobina; 2016: Abengoa; 2017: Agrokor. Past performance is not a reliable indicator of future results.

Myth 3: high yield is too speculative

Despite putting the default rate into perspective, some investors may still think of high yield bonds as too speculative, associating the asset class with indebted issuers in struggling sectors.

However, there is a lot of variety in terms of credit quality and industry sectors across the global high yield market. BB rated high yield bonds, those closest in nature to investment grade, account for just over a third of the global high yield universe, for example, with B rated bonds accounting for 55%. The most speculative bonds, those CCC rated and below, account for less than 9% of the global market.

Source: AXA IM / Bloomberg as at 30/09/2020. (HW00: ICE BofAML Global High Yield Index). The ratings shown are the linear average of the ratings for Moody's, S&P and Fitch rounded to the nearest integer.

In recent years, high yield bonds have also enjoyed strong support from central banks. Both the Bank of England and European Central Bank have purchased investment grade corporate bonds this year, providing an indirect support to high yield as an asset class. The Federal Reserve (Fed) has intervened more directly in the US, buying shares in exchange traded high yield funds.

Myth 4: there is too much correlation with equities

Over the past ten years, the correlation of global high yield with global equity has been 0.8.3 This is naturally higher than for other fixed income markets, but shows that high yield bonds still provide some important diversification benefits. This difference in behaviour can be seen in the historical performance of high yield and equities. The former typically tends to recover faster following bear markets, whilst also seeing lower peak to trough declines.4

Myth 5: rising interest rates threaten high yield returns

With the global economy still recovering from the pandemic, we believe interest rates are likely to remain low for some time. Even in a rate rising environment, however, high yield bonds can still deliver attractive returns, with the asset class typically less sensitive to rising interest rates as its higher yield effectively provides a cushion against rising rates.

This is particularly the case during periods of gradual adjustment, as seen in the US when the Fed raised rates from December 2015 to December 2018. High yield issuers typically benefit from the type of strong expansion which prompts central banks to begin raising rates. Investors can also choose to invest in shorter dated high yield bonds, which offer an efficient way to pick up yield without taking on the potential for too much short-term volatility.

Myth 6: equities are more predictable than high yield

Investors’ greater familiarity with equities may lead them to think that they are more predictable than high yield bonds. Yet equities have an inherently uncertain return profile, with total return tending to be more dependent on capital growth and starting valuation levels.

At AXA IM, we have a focus on compounding income, believing this is well suited to the high yield universe where high levels of carry are available. We would argue that the predictability of this income is an important advantage for the asset class, particularly when corporates are likely to hoard cash in the face of uncertainty and dividends remaining under pressure.

As the Covid-19 pandemic has shown, investors cannot count on equities to deliver a stable income. High yield issuers, however, are obliged to pay coupons to their bond investors, with default the only way out.

Myth 7: high yield bonds are too illiquid

As high yield bonds are traded over an exchange, rather than over the counter, they are less liquid than other securities. However, the expansion of the high yield market and increased investor demand has helped to improve liquidity dynamics.

Liquidity is something to take seriously, with some arguing that certain high yield investment vehicles – such as passives – carry inherent liquidity risks in their structures. At AXA IM, we also have our own specialist dealing team to help trade high yield bonds. Our size and “Tier 1” status ensure excellent access to the markets, critical when souring bonds in the market. By having an experienced team with deep local knowledge, we are constantly alert to opportunities in the high yield market, particularly during periods of distress.

Should high yield bonds be part of my portfolio?

Of course, all investment involves risk. Investors in high yield bonds can suffer capital loss if companies default on their debt or if bond issuers suffers a downgrading in their credit rating. The complex nature of high yield bonds means that this is an area for specialists, particularly when one thinks of liquidity risk – see immediately above – or the protection in legal documentation for bond issuances.

Nevertheless, for investors looking to diversify their risk exposure, or who want a higher income, we believe high yield bonds are an attractive option. The famous investor, André Kostolany, once observed that ‘those who want to eat well buy stocks (while) those that who want to sleep well buy bonds.’ With bonds much lower yielding nowadays, and equities returns inherently uncertain, investors may want to consider an asset class which offers them a little bit of both.

We have a range of high yield products at AXA IM, including global high yield, regional mandates and short duration products, allowing you to tailor your high yield allocation to your own requirements while benefitting from our specialist fixed income expertise, built up over more than three decades.  

Sources:

[1] ICE BofAML as at 30/09/2020. Performance is shown hedged in USD. Past performance is not a guide to future performance.

[2] Default data from Moody’s as at 30/06/2020. Historical data since December 2001.

[3] AXA IM, 03/11/2020. Global equities represented by MSCI World index and global high yield by the ICE BofA Global High Yield Index. 

[4] High yield bonds tend to recover faster because they are a ‘safer’ risk asset than equities, and so are first out on the recovery. Comparing US equities (S&P 500) and US high yield (ICE BofA US High Yield Total Return Index), for example, US high yield bonds saw quicker recovery times following the financial crisis and China deflation fears in early 2016. In 2020, however, they did lag US equities in recovering their previous highs, though only by nine days. On all three occasions (2009,2016 and 2020), US high yield bonds saw a lower drawdown than for US equities.

 

What are the risks of investing in high yield bonds?

Counterparty Risk: Risk of bankruptcy, insolvency, or payment or delivery failure of any of the Sub-Fund's counterparties, leading to a payment or delivery default.

Operational Risk: Risk that operational processes, including those related to the safekeeping of assets may fail, resulting in losses.

Liquidity Risk: risk of low liquidity level in certain market conditions that might lead the Sub-Fund to face difficulties valuing, purchasing or selling all/part of its assets and resulting in potential impact on its net asset value.

Credit Risk: Risk that issuers of debt securities held in the Sub-Fund may default on their obligations or have their credit rating downgraded, resulting in a decrease in the Net Asset Value.

Impact of any techniques such as derivatives: Certain management strategies involve specific risks, such as liquidity risk, credit risk, counterparty risk, legal risk, valuation risk, operational risk and risks related to the underlying assets.

The use of such strategies may also involve leverage, which may increase the effect of market movements and may result in significant risk of losses