Because high-yield bonds are a unique segment of the debt market—their performance behavior tends to run much closer to stocks than to U.S. Treasuries or other types of investment-grade bonds—different considerations come into play when deciding when and whether to invest. Let's look at the sets of circumstances that can help high yield bonds, as well as those that can cause them to lose value.
- The economy, investor sentiment, and the issuer's financial health all factor into deciding when you should buy high-yield bonds.
- High-yield bonds are typically evaluated on the basis of their yield spread relative to comparable Treasuries.
- High-yield bonds tend to be much less sensitive to the interest rate outlook than most areas of the bond market.
- High-yield bonds can help investors diversify their portfolios.
High Yield Bonds in a Booming Economy
While investment-grade bonds don’t typically respond well during periods of strong economic growth (since it can raise the demand for capital, causing interest rates to rise and bond prices to fall), a robust economy is a plus for the high-yield variety. This bond world is populated by smaller companies and those with weaker financials, which tend to benefit during an upswing in the economic cycle. This makes them less likely to default on their bonds, which in turn is positive for their prices – and investors’ total returns.
Expectations for Low or Falling Bond Default Rates
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 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.
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 dropped 26.2% during the financial crisis.
In this sense, high yield bonds tend to track stocks more closely than investment-grade bonds. Or, to put another way: What’s good for stocks is good for high yield bonds.
Above-Average Yield Spreads
High yield bonds are typically evaluated on the basis of their yield spread relative to comparable Treasuries—basically, the extra yield investors are paid for taking on the added risk of the bond. 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 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 lines, 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 Interest Rates
Some readers may be surprised that this discussion hasn’t mentioned movements in prevailing interest rates thus far. The reason: High-yield bonds tend to be much less sensitive to the interest 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 be one of the investors’ best options during periods of rising rates.
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. While investors should always make decisions based on their long-term goals and risk tolerance, these factors can convey when it makes the most sense to buy.
High yield bonds can help investors diversify their portfolios. Bear in mind, though, that since they perform similar to stocks, they provide diversification for a portfolio that’s heavily tilted toward investment-grade bonds, rather than one already heavily weighted in stocks.