Return and risk considerations while investing in high-yield bonds
High-yield or junk bonds are issued by borrowers that have a lower ability to service their debt obligations. They’re rated BB+ and below according to Standard & Poor’s credit ratings system. Since they have a relatively higher credit risk, investors demand higher yields.
Exchange-traded funds (or ETFs) like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the SPDR Barclays Capital High Yield Bond ETF (JNK), and the PowerShares Fundamental High Yield Corporate Bond ETF (PHB) mainly invest in debt issued by high-yield corporate borrowers.
Yields and spreads on high-yield corporate bonds
Treasuries have the lowest credit risk. They’re backed by the U.S. government. Yields on corporate bonds are based on a spread. The spread is calculated over yields on Treasuries of similar maturity. The spread is based on the bond’s credit risk. Higher credit risk implies higher spreads and vice versa.
Impact of economic cycles
Corporate borrowers’ debt-servicing ability is closely tied to economic conditions. When business conditions are favorable, corporate revenues and profits tend to be higher. It isn’t as hard for firms to discharge their debt obligations. Delinquency rates for high-yield debt issues are also lower. Credit spreads for high-yield bonds tend to narrow during economic expansions. As a result, junk bond returns and returns on stock indices usually move in the same direction. ETFs tracking large cap stock indices include the SPDR S&P 500 ETF (SPY) and the PowerShares QQQ (QQQ)
However, during a recession, business conditions aren’t favorable. Corporate revenues and profits tend to be lower. High-yield debt issuers face more difficulty in debt servicing. Due to the higher default risk, spreads tend to widen.
Lower secondary market liquidity is another concern for junk bonds during recessions. Due to an increase in market and economic risks during recessions, these bonds have fewer buyers. This widens the spreads even more. High-yield bond spreads reached an all-time high of 21.82% on December 15, 2008—during the financial crisis and the Great Recession.
This weekly update will analyze the key trends investors need to watch out for in the primary and secondary markets for high-yield debt securities. In the next part of the series, we’ll analyze primary market trends for high-yield corporate borrowers.
Visit the Market Realist U.S. Equity page to learn more about high-yield bonds.