High yield bonds

High-yield bonds, also known as Junk bonds, are bonds that carry a low credit rating. They are generally off limits for institutional investors because of their higher risk of default. Hence they are also known as non-investment grade bonds. Non-investment grade bonds are rated BB or lower (D means default); investment-grade bonds are BBB or higher, with AAAs at top, a status that government bonds in developed countries strive to attain or maintain.

High-yield bonds represent a small portion of fixed income markets (e.g., 5-7% of the U.S. taxable bond market).

History

Historically, most high-yield bonds were originally investment-grade bonds which were downgraded to junk status. These emitters are known as "fallen angels".

High-yield bonds were infamously promoted as an asset class by Michael Milken of Drexel Burnam Lambert in the 1980s as a means to finance leveraged buyouts. Milken was later jailed on charges of insider trading; and Drexel later failed, after posting its first losses in its history.

Since the mid-1980s, rather than being fallen angels, the majority of junk bonds are immediately rated as such for a variety of reasons, for example because they are growing companies issuing debt for the first time., or they are deemed too risky to be rated investment-grade.

Risks

Credit risk

High-yield bonds carry a lower rating because the issuing entity is considered to have a greater than average default risk – that is, there is a risk that it would not be able to pay its debts and be forced into bankruptcy. Should bankruptcy occur, bondholders would probably receive significantly less than the face amount of the bonds. For the period 1978-1997, the default rate on US high-yield bonds ranged from 0.2% to 10.3%. Among defaulting issues, the average recovery was about 40% of face value during this period. Since 1997, the default rates have ranged from less than 2% to over 10%.

Call risk

Issuers typically call their bonds when the interest rate goes down. High yield bonds come with additional call risk. If the issuers' credit ratings improve, they can call the existing bonds and borrow money at a lower interest rate. This type of call risk is not applicable to bonds with high ratings.

In 2018, 98% of bonds in the Barclays U.S. Corporate High Yield Bond Index had a call feature.

Skewness

Junk bonds have negatively skewed returns, meaning that there is a long tail of low returns in the distribution. In ther words, there are more large losses than a normal distribution would imply. This is true of many asset classes, but the negative skew of junk bonds is worse than that of equities or investment-grade bonds.

A comparison with the equity market is illustrative of high yield’s higher negative skew. Investors who hold a bond to maturity can earn no more than the coupon — and they risk losing everything in the event of a full default. By contrast, equity investors also risk losing 100% of their investment, but the upside potential is unlimited.

Canada versus US

Canadian bonds are rated by three bond rating agencies: DBRS, Moody's and Standard and Poor's, which bought the Canadian Bond Rating Service in 2000.

The Canadian market for high-yield bonds is comparatively small: as of December 2018, the FTSE TMX Canada High Yield Bond Index contained 43 issues with a total market value of 11 billion Canadian dollars.

In contrast, the US is the largest junk bond market in the world, worth about 1200 billion US dollars as of July 2018.

Place in portfolios

High-yield bonds can add additional income but carry higher risks. Because of these risks, authors disagree on their use in a portfolio. In a Bogleheads topic, the different approaches of investment authors Richard Ferri and Larry Swedroe is discussed: Ferri thinks that high-yield bonds have a place in portfolio design but Swedroe disagrees. The poor performance of some Canadian high-yield bond funds in 2008 has been noted by Luukko.

Arguments for

• The higher yield relative to investment-grade bonds: an average of 5% extra yield in the US during 1987-2012 (do not confuse this 5% extra yield with a 5% extra total return: defaults have to be accounted for)
• On individual bonds, a possibility of capital gains if the issue is upgraded to a better rating
• Diversification benefit due to low correlation with other types of fixed income

Argument against

• Bonds are supposed to be safe and provide ballast, but high-yield bonds are volatile
• High-yield bonds can be correlated with equities, and go down in price along with equities during bear markets
• They can be difficult to trade in a bear market
• According a Vanguard study, adding high-yield bonds to a portfolio of investment-grade bonds and equities did "not significantly boost a portfolio's risk-adjusted returns" for the period 1986-2013, i.e. junk bonds are not actually good portfolio diversifiers
• Very few of the active mutual funds, and none of the ETFs, managed to match or beat the U.S. Corporate High Yield Bond Index (over 5 years) due to factors such as liquidity costs and other expenses

Implementation

Due to the high risk of this asset class, investors could very easily choose not to include it at all in their portfolios. For those that want to go ahead:

• The amount of high-yield debt in the portfolio should be limited. Ferri recommends that 10-20% of the total bond allocation be in high-yield debt. Other investors count junk bonds in the equity category: they keep their investment grade bonds intact, but allocate some of their risky assets (typically, equities) to junk bonds.
• The high default risk makes diversification essential, and high trading costs make individual bond purchases unwise, so investors should almost always purchase high-yield bonds as part of a low cost mutual fund or exchange-traded fund (unless they are willing and able to analyze corporate debt structure and diversify across many issues)

Filters to sort mutual fund performance can be obtained from Globefund and Morningstar. There is a Financial Wisdom Forum topic discussing the Phillips, Hager, and North High-Yield Bond Fund, but it has had mixed returns relative to the relevant index over the last ten years, and is closed to new investors anyway.

External links

• Bogleheads wiki: High-yield bonds