Understanding Investing

High Yield Bonds

High yield bonds – defined as corporate bonds rated below BBB− or Baa3 by established credit rating agencies – can play an important role in many portfolios. They typically offer higher coupons than government bonds or high grade corporate bonds (or, corporates) and have the potential for price appreciation in the event of an improvement in the economy, or performance of the issuing company (of course, if these conditions worsen, then prices can also go down). Because the high yield sector generally has a low correlation to other sectors of the fixed income market along with less sensitivity to interest rate risk, an allocation to high yield bonds may provide portfolio diversification benefits. In addition, high yield bond investments have historically offered similar returns to equity markets, but with lower volatility.

What makes a bond high yield?

Credit rating agencies evaluate bond issuers and assign ratings. Issuers are rated on their ability to pay interest and principal as scheduled. Those issuers considered to have a greater risk of defaulting on interest or principal repayments are rated below investment grade (see Chart 1). These issuers must therefore pay higher coupons to attract investors to buy their bonds.

While agency credit ratings define the high yield market, and many investors rely on these ratings in their portfolio guidelines, investors may also conduct independent credit analysis of company fundamentals and other factors to form their own conclusions about a security’s risk of default.

Who issues high yield bonds?

Until the 1980s, high yield bonds were simply the outstanding bonds of “fallen angels” – former investment grade companies that had been downgraded below investment grade. Investment banks, led by Drexel Burnham Lambert, launched the modern high yield market in the 1980s by selling new bonds from companies with below-investment grade ratings, mainly to finance mergers and acquisitions or leveraged buyouts.

The high yield market has since evolved, and today, much high yield debt is used for general corporate purposes, such as financing capital needs or consolidating and paying down bank lines of credit. Mainly focused in the U.S. through the 1980s and 1990s, the high yield sector has since grown significantly around the globe in terms of issuance, outstanding securities and investor interest.

New high yield issuance can vary greatly from year to year depending on economic and market conditions, typically expanding along with economic growth, when investors’ appetite for risk often increases, and waning in recessions or market environments, when investors are more cautious.

The high yield sector includes both originally-issued high yield bonds and the outstanding bonds of fallen angels, which can have a significant impact on the overall size of the market if large or numerous companies are downgraded to high yield status. Conversely, the sector can shrink when companies are upgraded out of the speculative grade market into the investment grade sector.

Why invest in high yield bonds?

High yield bonds may offer investors a number of potential benefits, coupled with specific risks. Investors can endeavor to manage the risks in high yield bonds by diversifying their holdings across issuers, industries and regions, and by carefully monitoring each issuer’s financial health.

  • Diversification – High yield bonds typically have a low correlation to investment grade fixed income sectors, such as Treasuries and highly rated corporate debt, which means that adding high yield securities to a broad fixed income portfolio may enhance portfolio diversification. Diversification does not insure against loss, but it can help decrease overall portfolio risk and improve the consistency of returns.
  • Enhanced current income – To encourage investment, high yield bonds usually offer significantly greater yields than government bonds and many investment grade corporate bonds. Average yields in the sector vary depending on the economic climate, generally rising during downturns when default risk also rises (high yield companies may be more negatively affected by adverse market conditions than investment grade companies). For example, for much of the 1980s and 1990s, U.S. high yield bonds typically offered 300 to 500 basis points of additional yield relative to U.S. Treasury securities of comparable maturity, according to the Securities Industry and Financial Markets Association. But following the credit crisis in 2007–2008, the spread between high yield and government bonds was much greater reaching highs of close to 2,000 basis points.
  • Capital appreciation – An economic upturn or improved performance at the issuing company can have a significant impact on the price of a high yield bond. This capital appreciation is an important component of a total return investment approach. Events that can push up the price of a bond include ratings upgrades, improved earnings reports, mergers or acquisitions, management changes, positive product developments or market-related events. Of course, if an issuer’s financial health deteriorates, rating agencies may downgrade the bonds, which can reduce their value.
  • Equity-like, long-term return potential – High yield bonds and equities tend to respond in a similar way to the overall market environment, which can lead to similar return profiles over a full market cycle. However, returns on high yield bonds tend to be less volatile because the income component of the return is typically larger, providing an added measure of stability. In addition, the combination of enhanced yield and the potential for capital appreciation (though less than for equities) means that high yield bonds can offer equity-like total returns over the long term. Also, bondholders have priority over stockholders in a company’s capital structure in the event of bankruptcy or liquidation; high yield bond investors therefore have a greater chance of recovering their investment than equity investors.
  • Relatively low duration – One reason high yield bonds often have relatively low duration is that they tend to have shorter maturities; they are typically issued with terms of 10 years or less and are often callable after four or five years. Generally, high yield bond prices are much more sensitive to the economic outlook and corporate earnings than to day-to-day fluctuations in interest rates. In a rising rate environment, as would be expected in the recovery phase of the economic cycle, high yield bonds would be expected to outperform many other fixed income classes. That said, the high yield sector does not demand great economic times; most issuers may function very well and continue to reliably service their debt in a low growth environment.

What are the risks?

Compared to investment grade corporate and sovereign bonds, high yield bonds are more volatile with higher default risk among underlying issuers. In times of economic stress, defaults may spike, making the asset class more sensitive to the economic outlook than other sectors of the bond market. High yield bonds share attributes of both fixed income and equities, and can be used as part of a diversified portfolio allocation.

Related Insights

Section:
Tag:
Date:
Expert:
Ticker:
Reset All

Disclosures

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Investors should consult their investment professional prior to making an investment decision.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

BofA Merrill Lynch U.S. High Yield, BB-B Rated, Constrained Index tracks the performance of BB-B Rated US Dollar-denominated corporate bonds publicly issued in the US domestic market. Qualifying bonds are capitalization-weighted provided the total allocation to an individual issuer (defined by Bloomberg tickers) does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face value of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Investments LLC, U.S. distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe Ltd - Italy (Company No. 07533910969) is authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the U.K. The Italy branch is additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Swedish Branch is additionally supervised by the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act. he services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia). This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1o andar, Rio de Janeiro – RJ Brasil 22210-906. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and the NEW NEUTRAL are trademarks of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2017, PIMCO.

CMR2017-0831-287445