Individual Investors

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Why Invest in High Yield Bonds?

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Bonds issued by companies with credit ratings below investment grade – variously called “sub-investment grade” or “high yield” – have fallen to multiyear lows, as lenders fear that a stalling global economy and higher interest rates will undermine companies’ ability to repay.

Credit Ratings

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The Solactive USD High Yield Corporates Total Market Index, which measures high yield bonds issued in US dollars, is down almost 15% year-to-date. The only other times high yield bond indexes have fallen so far so fast in recent memory were the 2008 financial crisis and the 2020 covid-19 selloff.

While the drawdown may be unsettling, it offers a chance to review the merits of this often-misunderstood asset class.

1. Lower duration for rising rates

Investors seeking higher income from corporate bonds are typically required to choose between one of two risks. First is interest rate risk, which is the risk that interest rates rise. Higher interest rates typically cause bond prices to fall. Second is credit risk, which is the greater risk that comes with lending to companies in ruder financial health.

High Yield Bonds Have Outperformed Investment Grade Corporates as Rates Rise

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While high yield bonds take on more credit risk, they typically take on less interest rate risk than their investment grade peers. This is reflected in their lower duration.

This means that when interest rates rise, as they have in 2022, high yield bond ETFs can – perhaps counterintuitively – provide more capital stability, while also providing a higher yield than investment grade corporate bonds.

2. Significantly higher potential yields

High yield US corporate bonds offer substantially larger yields than investment grade corporate and government bonds. The Solactive USD High Yield Corporates Total Market Index is providing a yield to maturity of 8% as of 27 June. This compares to the 4.2% provided by the Bloomberg US Corporate Bond Index and 3.7% on the Bloomberg US Aggregate Bond Index.

High Yield Can Provide Significantly Higher Income

High_yield_can_provide_significantly_higher_income_0200865ee6.pngSource: Bloomberg. Data as of 27 June 2022.

The benefits of these higher yields to those depending on income are obvious. But large coupons also have portfolio benefits.

These include providing a diversified source of returns. When central banks froze interest rates at zero, investors could rely on bonds – especially investment grade and government bonds – providing capital appreciation. However with US headline inflation now above 8%, investors cannot rely on bonds providing capital growth. Bonds rise in value in deflationary environments but fall in value when inflation rises.

In this setting, higher coupons can limit the effects of falling bond values. This is because the price of bonds needs to fall by a value larger than their yields for investors to suffer a loss on a total return basis. We have seen this in 2022, as higher coupons have offset – to some extent, but not completely – falling bond values for high yield bonds.

3. Default rates are forecast to remain low

The primary risk of investing in high yield bonds is the lower creditworthiness of issuers. However, at the time of writing (June 2022) default rates for sub-investment grade borrowers are low. To this end, there were only five defaults in the Solactive USD High Yield Corporates Total Market Index in May 2022, in a portfolio of over 1200 bonds.

Leading ratings agencies expect that default rates for high yield bonds will stay low, too. S&P Globa