High yield bonds offer lower volatility than equities due to their coupon income.
High Yield Bonds Should be a Strategic Allocation.
- In most cases, the high yield market meets the actuarial assumption of a 7%-8% return, which is generated predominantly by an annual income stream.
- High yield securities have historically produced significantly higher risk-adjusted returns than most other fixed income sectors.
- In down markets, a larger coupon for high yield securities helps to offset market declines, and in up markets high yield securities usually correlate to rising equities.
- High yield securities have attributes that enable investors to benefit from corporate developments as well as enjoy the characteristics of fixed income.
- High yield bonds are generally not impacted by modest rises in interest rates. Additionally, spreads are more a reflection of market expectations for future default rates rather than expectations for higher interest rates.
Investors should not be misled by the common myths associated with high yield.
Five Myths of the High Yield Market.
- Yield compensates for credit risk.
- The Reality – The high yield market is characterized by asymmetric risk whereby the potential for downside losses outweighs upside capital appreciation.
- The market is deep and liquid.
- The Reality – The high yield market is an over-the-counter market that is highly dependent on dealer capital. The majority of high yield bonds do not trade on a daily basis, which means there may be a significant difference between trade prices and broker quotes.
- Credit ratings reflect the actual risk.
- The Reality – Independent fundamental analysis is paramount. Additionally, the market generally anticipates upgrades and downgrades long before the actual rating changes.
- High yield bonds correlate to U.S. Treasuries.
- The Reality – Over the last 26 years there have been six periods during which the 10-year Treasury yield has risen more than 100 basis points. High yield bonds and leveraged loans had positive returns during each of these periods.
- Spreads correlate to interest rates.
- The Reality – Historically, spreads have been a reflection of the expected default rates over a six- to nine-month period. An expectation of low default rates typically results in spread compression.