High-yield bonds are a unique segment of the debt market. They tend to perform much closer to stocks than to U.S. Treasuries or other types of investment-grade bonds.
Because of this, you'll need to consider different factors when deciding when and whether to invest in these bonds. Learn about what market changes can help high yield bonds and what can cause them to lose value.
- The economy, investor sentiment, and the issuer's financial health will all affect whether you should buy high-yield bonds.
- High-yield bonds are often evaluated on the basis of their yield spread compared to similar Treasury bonds.
- High-yield bonds tend to be much less sensitive to the interest rate outlook than other areas of the bond market.
- High-yield bonds can help you diversify your portfolios.
What Happens to High Yield Bonds in a Strong Economy?
Investment-grade bonds don’t typically respond well during periods of strong economic growth. This is because a strong economy can raise the demand for capital, which causes causing interest rates to rise and bond prices to fall,
But a robust economy is good for high-yield bonds. This bond world is made up of smaller companies, as well as those with weaker financials.
These kinds of companies tend to gain during an upswing in the economic cycle. Their growth makes them less likely to default on their bonds. This in turn is good for their prices, which is good for the total return on your investment.
What Happens With Low or Falling Bond Default Rates?
The high yield default rate is the percentage of issuers that fail to make interest or principal payments on their bonds. This is a key consideration for the high yield market.
The lower the default rate, the better for the market. But what investors expect for the future default rate can be even more important than the current rate.
In other words, if the default rate is low now but expected to rise in the year ahead, that would indicate a weaker future. This might make you hold off on investing.
On the other hand, you may decide to invest if the current default rate is high but expected to go down in the near future.
How Do Investors Feel About High-Yield Bonds?
High-yield bonds are a higher-risk asset than other types of bonds. They tend to be popular when investors are feeling optimistic. They also suffer when investors grow nervous and seek safe havens.
This is shown in the negative returns for high-yield bonds in 2002. That year, they returned -1.5% amid the popping of the dot.com bubble. And in 2008, they dropped 26.2% during the financial crisis.
In this sense, high-yield bonds tend to track stocks more closely than they do investment-grade bonds. What's good for stocks is good for high-yield bonds.
What Are Above-Average Yield Spreads?
High yield bonds are often judged on the basis of their yield spread relative to similar Treasury bonds. This is the extra yield you are paid for taking on the added risk of the bond.
When spreads are high, it shows that the asset class is in distress. It has more room for future appreciation. It is also a potential “contrarian” opportunity.
Lower spreads show that there is less potential upside. It also signals that there is a greater risk if you invest.
A prime example happened in 2008. Yield spreads blew out to all-time highs over Treasuries in the depths of the financial crisis.
If you took advantage of this, you would have benefited from the 59% return in high-yield bonds during 2009.
Along the same lines, the record-low spreads of 1996-1997 foretold a future of subpar returns. This happened in the 1998-2002 time period.
The key, as always, is to look for opportunities when an asset class is underperforming. This is a better time to invest than when it’s putting up exceptional return numbers.
What Is the Impact of Interest Rates?
The bond market tends to react strongly to changes in interest rates. But high-yield bonds don't act like other bonds.
High-yield bonds tend to be less sensitive to the interest rate outlook. It’s true that when yields move sharply higher or lower, high-yield bonds will often go along for the ride. But modest yield movements don’t always have to weigh on high yield.
This is because rising yields in the rest of the market are often the result of economic growth. This is a positive for the asset class.
In fact, high-yield bonds are more likely to move in the same direction as stocks. They may move in the opposite direction from investment-grade bonds over time. This means that they may be a smart choice for you to invest in during times of rising rates.
The Bottom Line
High-yield bonds tend to perform best when growth trends are favorable, investors are confident, defaults are low or falling, and yield spreads provide room for more growth.
You should always make decisions about whether to invest based on your long-term goals and risk tolerance. But these factors can tell you when it makes the most sense to buy.
High-yield bonds can help you diversify your portfolios. Bear in mind, though, that they perform similar to stocks. This means they provide diversification if your portfolio is tilted toward investment-grade bonds. If it's already heavily weighted in stocks, they won't diversify your investments very much.