The riskiness of lower-quality bond issuers is driven by the same fundamentals as stock returns
As the economy recovers, the risk of default falls for small or highly levered companies that rely on debt financing. Higher growth means more productivity and higher sales, which allow companies to take on and service more debt. Because of this, the spreads on high-yield debt widen as economic fundamentals deteriorate and tighten as they improve. The “spread” on a bond is the difference between the bond’s yield and the yield of the risk-free bond (such as Treasury securities) with the closest maturity. When bond investors think about bonds, they focus on yields and spreads—not prices like with stocks. Spreads represent the compensation that investors demand for exposing themselves to credit (or default) risk, which is the probability that they won’t receive their principle back.
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Investing involves trade-offs between risk and return. For example, suppose that a company issues stock and two types of debt, senior secured and subordinated unsecured. Because the senior secured bonds are backed by collateral that the bondholders have claim to in the event of a default, the spread demanded by investors is lower than the subordinated unsecured bonds, which not only aren’t backed by collateral, but are also only paid in bankruptcy after the senior bonds have been made whole. The shareholders only have a residual claim and take the first loss in a credit event, so the equity risk premium is greater than the credit spread on the bonds.
High-yield debt could do well going forward, but there are risks
Like equities, high-yield debt experienced increased volatility going into the September Fed meeting. The Fed shifting toward more contractionary monetary policy poses two risks to high-yield debt: first, the market could expect short-term rates to normalize sooner, increasing current longer rates. Second, the market could interpret a less accommodative stance by the Fed as a negative for the economy and demand higher credit spreads for compensation.
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