Investing in High Yield Bonds

Many investors incorrectly consider high-yield bonds to be like other bonds, especially treasury bonds. But seasoned investors know that high-yield bonds are more closely tied to stocks and the factors that move them. Their high yields give the bonds a bit of an advantage over stocks, generating higher total returns over most periods and often limiting losses somewhat in downturns. But high-yield bonds still can sustain major losses in bad times.

If you’re a high-yield investor, don’t pay much attention to financial media discussions. Instead, read this piece from PIMCO. It provides important points about high-yield bond returns and default rates on the bonds and the more important connection between stocks and high-yield bond returns.

That last observation may be particularly intriguing: Why is the high yield/equity correlation higher now (post 2008) than longer-term history would indicate? Generally, during the recovery phase that follows recessions (when risk assets rebound from trough levels), the upside in high yield bonds tends to peak (get capped) due to the negative convexity of the asset class (i.e., most high yield bonds have call options that enable the issuer to retire the bond before maturity). In contrast, equities can continue rallying if investors believe growth will persist.

Today, however, the slow economic recovery (what PIMCO calls the New Normal) means net debt/EV levels remain elevated and hence spreads are all the more sensitive to changes in equity levels. In fact, by analyzing spread behavior at the individual credit level, we find equity valuations are one of the strongest factors affecting high yield spreads. Figure 6 plots the same set of high yield CDS spreads shown in Figures 4 and 5, but now in detail at a single point in time (31 August 2012) vs. net debt/EV. Notice the increasing slope of the regression fitted line: As the proportion of debt in the enterprise value goes up, or in other words, as the equity cushion shrinks, spreads widen out in a non-linear manner. All else being equal, one would expect increasing probability of default as a company’s debt burden increases in relation to its total worth. This is why at elevated net debt/EV levels, high yield is likely to be more sensitive and more correlated to equities.