When Is the Best Time to Buy High Yield Bonds?
High-yield bonds are a unique segment of the bond market since their performance characteristics tend to run much closer to stocks than they do U.S. Treasuries or other types of investment-grade bonds. Below, we look at the sets of circumstances that can help high yield bonds, as well as those that can cause them to lose value. Together, these considerations help illustrate the way that high yield bonds can help investors achieve better portfolio diversification.
When Do High Yield Bonds Typically Perform Well?
Strong economic growth: While investment-grade bonds don’t typically respond well to stronger growth (since it can raise the demand for capital, causing rates to rise and bond prices to fall), a robust economy is a plus for high yield. Since the asset class is populated by smaller companies and those with weaker financials than the typical investment-grade corporate issuer, a strong economy leads to improving financial health for high yield companies. This makes them less likely to default on their bonds, which in turn is a positive for their prices – and investors’ total returns.
This chart, from the St. Louis Fed database (FRED), shows the underperformance of high yield during recessions and its relative strength in periods of expansion.
Expectations for low or falling defaults: The high yield default rate, or the percentage of issuers that fail to make interest or principal payments on their bonds, is a key consideration for the high yield market.
The lower the rate, obviously, the better the backdrop for the market. More so than the current rate, however, the most important issue is what investors expect regarding the future default rate. In other words, if the default rate is low now but expected to rise in the year ahead, that would be a headwind to performance.
Conversely, a high default rate with expectations for improvement is generally positive.
Investors can keep track of developments on this front by following the topic in the financial media. A good source of aggregated content on high yield is the news feed for high yield ETFs such as the iShares High Yield Corporate Bond Fund (HYG), which can be viewed here. A chart of recent default rates (through 2012, not updated) is available here.
Elevated investor optimism: High-yield bonds are a higher-risk asset, which means they tend to be popular when investors are feeling optimistic but suffer when investors grow nervous and seek safe havens. This is reflected in the negative returns for high-yield bonds in 2002, when they returned -1.5% amid the popping of the dot.com bubble, and in 2008, when they shed -26.2% during the financial crisis. In this sense, high yield tends to track stocks more closely than investment grade bonds.
Put another way, what’s good for stocks is good for high yield.
Above-average yield spreads: High yield bonds are typically evaluated on the basis of their “yield spread” relative to comparable Treasuries, or in other words, the extra yield investors are paid for taking on the added risk.
When spreads are high, it indicates that the asset class is in distress and has more room for future appreciation (not to mention being a potential “contrarian” opportunity. Conversely, lower spreads indicate that there is less potential upside – and also greater risk.
A prime example occurred in 2008. Yield spreads blew out to all-time highs over Treasuries – as shown here – in the depths of the financial crisis. An investor who took advantage of this would have benefited from the 59% return in high yield bonds during 2009. Along the same line, the record-low spreads of 1996-1997 foretold an extended period of subpar returns in the 1998-2002 interval.
The key, as always, is to look for opportunities when an asset class is underperforming rather than when it’s putting up exceptional return numbers.
The Impact of Rising and Falling Rates
Some readers may be surprised that this discussion hasn’t mentioned movements in prevailing rates thus far. The reason for this is that high-yield bonds tend to be much less sensitive to the rate outlook than most areas of the bond market. It’s true that when yields move sharply higher or lower, high yield bonds will often go along for the ride. However, modest yield movements don’t necessarily have to weigh on high yield, since rising yields in the rest of the market are frequently the result of improving economic growth – which, as noted above, is a positive for the asset class. In fact, high yield bonds have been more closely correlated with stocks than they have with investment-grade bonds over time – meaning that they may therefore be one of investors’ best options during periods of rising rates.
What this Tells Us about High Yield
For investors considering high yield bonds, the facts set forth above should tell an important story: while high yield bonds can provide diversification for a portfolio that’s heavily tilted toward investment-grade bonds, they provide much less diversification for someone who’s invested in stocks. The issue is covered in greater detail in my article, Using High Yield Bonds for Diversification.
The Bottom Line
High yield bonds perform tend to perform best when growth trends are favorable, investors are confident, and defaults are low or falling, and yield spreads provide room for additional appreciation, whereas they typically lag when the opposite is the case. While investors should always make decisions based on their long-term goals and risk tolerance, these factors can provide a sense of the times when it makes the most sense to buy high yield bonds.
Learn more: How have high yield bonds performed over time?
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.