By Darren Hughes and Scott Roberts, Senior Portfolio Managers and Co-Heads of High Yield Investments for Invesco Fixed Income
Over the past three years, the bond market has witnessed a massive cycle of refinancing as companies are trying to lower their cost of debt before the expected interest rate rise. That has led to above-par prices for the high yield market, which in turn has led to reluctance among some investors to buy these bonds now. That's because they're following the conventional wisdom - if bonds are trading at a discount to par value, buy. If they are trading over par value, don't.
But this simple rule of thumb ignores an important aspect of the high yield market - call protection - that may generate returns for investors even when the market is trading above par.
Parsing the value of par value
Par value is the amount of money an investor is scheduled to receive once a bond matures. Conventional wisdom would say that paying above par value for a bond investment should result in a loss for investors, and paying below par should bring gains. However, as shown in the chart below, the high yield market doesn't always perform according to conventional wisdom.
At the end of 2012, the high yield market was trading at $104.62 - more than 4% above its $100 par value. By the end of 2013, the market price dropped by 90 cents, yet it returned 7.44% for the year. You can see this same trend from 2010 to 2011, from 2006 to 2007 and 2004 to 2005.
On the flip side, notice what happened from 2007 to 2008. On Dec. 31, 2007, the high yield market was trading at $92.61, which may seem like a deal versus its $100 par value. However, the market lost 26.16% during 2008. The same trend occurred from 2001 to 2002, 1999 to 2000 and 1993 to 1994.
The details about call protection
In the high yield market, dollar prices may often exceed par due to call protection. What does that mean? When companies decide to refinance their debt and pay lower interest rates, they will "call" their bonds and pay back investors before the scheduled maturity date. For that privilege, the companies will normally pay a pre-payment penalty that is added to the returns for the high yield bond. That means high yield investors typically could receive between $102 and $105 for a bond that's called early, versus the $100 par price.
As high yield managers, we carefully evaluate call protection in our pursuit of positive total returns. We often buy bonds above par, but only when we believe they can earn an attractive return.
The Barclays U.S. Corporate High Yield 2% Issuer Cap Index is an unmanaged index comprising U.S. corporate, fixed-rate, noninvestment-grade debt with at least one year to maturity and at least $150 million in par outstanding. Index weights for each issuer are capped at 2%. An investment cannot be made directly in an index.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
If interest rates fall, it is possible that issuers of callable securities will call or prepay their securities before maturity, causing the Fund to reinvest proceeds in securities bearing lower interest rates and reducing the Fund's income and distributions.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer's credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
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All data provided by Invesco unless otherwise noted.
Invesco Distributors, Inc. is a U.S. distributor for retail mutual funds, exchange-traded funds, institutional money market funds and unit investment trusts.
Invesco unit investment trusts are distributed by the sponsor, Invesco Capital Markets, Inc. and broker dealers including Invesco Distributors, Inc. These Invesco entities are indirect, wholly owned subsidiaries of Invesco Ltd.
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Disclosure: The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author(s), are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.