Be Aware of Key Drivers and Risk Factors in High Yield Bonds

Includes: HYG, JNK, PHB
by: Richard Shaw

Junk bonds can be useful in portfolios, but in differing proportions based on position in the economic cycle. Be mindful that higher yield is not free – it comes with higher volatility risk (temporary capital gain and loss) and some degree of default risk (likely permanent capital loss). Look beyond the fund name, and into the composition of credits in the portfolio, before you buy.

Based on a paper issued by the Federal Reserve in 1996, variation in annual default rates for high yield (below investment grade) bonds is explained by three key factors:

  1. Changes in the mix of credit ratings within the aggregate high yield universe;
  2. The average age of the outstanding high yield bonds;
  3. The state of the economy.

Good times in the economy and stock markets tend to permit more lower quality companies to issue bonds, thus lowering the aggregate credit quality of the high yield universe.

Default rates are low in the first year after issuance and become highest after three years, because (a) the market makes it very difficult for companies approaching default to issue bonds, and (b) immediately after issuing high yield bonds, companies have cash on hand to pay interest on their bonds. However, after three years, the cash on hand is likely to be less, and operational difficulties in the company have had time to mature.

In a rising or good economy, profits tend to rise for weak as well as strong companies, thus reducing the probability of high yield issuers being unable to service their debt. However, in a declining or poor economy the weaker companies tend to weaken more than the investment grade companies. Not only do the investment grade companies tend to have stronger balance sheets, but they tend to have stronger business franchises and greater access to refinancing credit than below investment grade companies.

Not mentioned in the Federal Reserve paper, but mentioned in a New York University paper by Professor Edward Altman, is the intuitively obvious fact that the mix of industries in the high yield universe also influences the aggregate default rate.

Of minor significance, and generally out of research reach (or at least effort) of most retail investors is whether the high yield bond was issued when the company was investment grade (a “fallen angel”), or issued when the company was already below investment grade. Fallen angels have slightly lower default rates.

Here is a table (click to enlarge images) of annual default rates for bonds of various credit qualities based on the number of years since issuance (from an article by Edward Altman of NYU):

This table shows pretty clearly that for junk bonds, knowing the age of the bond is important. Unfortunately, bond funds generally don’t tell you the age of their holdings. They tell you when they mature, but they don’t tell you when they were issued.

When buying high yield bond funds (short of extraordinary levels of bond-by-bond research), you have to rely on the assumption that the manager has taken this aging attribute of the holdings into consideration before adding it to the portfolio.

However when you buy high yield bonds individually, this data would suggest being mindful of the issue date as well as the maturity date.

More importantly though, we think buying high yield bonds individually is generally not a good idea. Spread of risk across many issuers, and multiple industries is critical. A 3% default rate, for example, for a bond rating category is of little consolation if you hold one or a few high yield bonds, and you hold the one or ones that default.

Even if you have the credit analysis skills of a bond analyst, and even if you put in the time and effort to study bonds the way they do, you can’t escape the fact that sometimes your right and sometimes your wrong. Good diversification is the only real solution to that risk.

As a general rule, the more research is required to make a decision on a category of securities, or the less comprehensive research is readily available; the more you need to focus on owning funds versus owning individual securities.

It’s not just the situation for bonds. For example, foreign stocks tend to need funds more than domestic stocks. Small-cap stocks tend to need funds more than large-cap stocks. Low quality bonds tend to need funds more than high quality bonds.

Here is a table that accumulates the annual default rates by credit quality over the first 10 years after issuance, based on data from 1971 through 2006 (by Moody’s and Professor Altman) and from 1981 through 2006 (by Standard and Poor’s):

Here is a tally of cumulative default among high yield bonds for 29 years from 1981 through 2010, using S&P data, taken from an Edward Jones brochure:

Here is a Standard and Poor’s table of annual default rates from 1981 through 2008 for bonds of various credit quality ratings without regard to the age of the issue when it defaulted:

Takeaways for junk bond investors:

  1. It's generally best to buy a fund and not individual junk bonds;
  2. Be aware of the credit rating composition of your high yield bond funds;
  3. know whether the economy is getting better or worse;
  4. (If you are buying individual bonds) know the age of the issue.

Presumably modulate allocation to junk bond funds by reducing high yield allocation in a declining economy and increasing high yield exposure in a rising economy.

Remember too, that rising interest rates tend to cause bonds of all quality ratings to fall in market value.

All bonds are not created equal, and yield is not the only factor to examine. Look beyond the bond fund name at the holdings to make sure you know what you are getting and whether it is suitable for you. Fund names are notoriously unhelpful in understanding the underlying assets.

Here are data tables for three high yield ETFs and three high yield mutual funds (selected for high concentrations of B and below B grade bonds), and three investment grade bonds. None of these is presented as a recommendation, merely as representative high yield fund offerings.

You can see the wide variations in credit quality distribution within the portfolios; and also how the “average credit quality” attributed to each fund inadequately informs you as to the composition and distribution.

For example, JNK has an average quality of “B” with no exposure below “B”; whereas AYBFX also has an average quality of “B” and 29.50% of holdings below “B”. This is not to say that one is better than the other, but that average credit quality is just a first level look that needs a deeper view into the mix.

This table provides some additional return and other data for those funds:

It is also important to remember that high yield bonds have tended to behave more like stocks and less like investment grade bonds. The following charts show the percentage performance of high yield bonds versus the S&P 500 index ETF (NYSEARCA:SPY) compared to investment grade bonds versus SPY.

SPY is in black line. Junk bonds are in solid colored lines. Investment grade bonds are in dashed colored lines.

3 Years Monthly

1 Year Weekly

3 Months Daily

Junk bonds can be useful in portfolios, but in differing proportions based on position in the economic cycle. Be mindful that the higher yield is not free – that it comes with higher volatility risk (temporary capital gain and loss), and some degree of default risk (likely permanent capital loss). Look beyond the fund name, and into the composition of credits in the portfolio, before you buy.

High yield bond investing is complicated stuff, best left to credit analysts and bond managers who make that their career focus.

Disclosure: We hold SPY in some but not all managed accounts as of the publication date of this article.

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on our site available here.