What are high yield bonds? I don't mean the textbook definition (corporate bonds with a credit rating below BBB), but how they actually behave in terms of risk and return.
In attempting to answer this question, let's address some common myths surrounding the asset class affectionately known as "junk bonds."
Myth #1: High Yield Bonds Act More Like Bonds than Stocks
Junk bonds are bonds, so they should act more like other bonds than stocks, right?
Wrong. With a correlation to stocks of 0.58 and a correlation to bonds of 0.24, junk bonds are more likely to move with the U.S. stock market than the aggregate bond market.
Note: Throughout this post I am using the BofA Merrill Lynch High Yield Bond Index (total return) as a proxy for high yield bonds. This index dates back to September 1986.
Myth #2: High Yield Bonds are Riskier than Stocks
When junk bonds are down more than stocks (13% of all months), we often hear that they are riskier than stocks. While that may appear to be the case at times, their overall risk profile does not support such a conclusion:
- The annualized volatility of high yield, at 8%, is significantly lower than the equity market at 14.9%.
- The maximum drawdown for high yield bonds of 33% is also significantly below the equity market at 51%.
- The average up/down month for high yield bonds is roughly half that of the equity market.
- The 15 worst months for high yield bonds is only about half as bad as the equity market on average.
- With upside/downside capture ratios of 41%/26%, respectively, the movement in high yield bonds is often a fraction of the movement in equities. High yield's historical beta to the S&P 500: 0.31.
Myth #3: High Yield Bonds Always Move Up/Down with Stocks
Just because junk bonds are correlated with stocks over the long run doesn't mean they always move in the same direction. Historically, they have moved together in 76% of months. That means in roughly 1 out of every 4 months, or 3 times per year on average, they are moving in opposite directions.
Interestingly, much of this differential behavior seems to occur in months when stocks are down. During such months high yield bonds have actually been positive 47% of the time. In contrast, during months when stocks are up, high yield bonds have been up 88% of the time.
Myth #4: High Yield Investors Should Fear Rising Rates
The greatest fear of most bond investors is higher interest rates, and they naturally extend that fear to high yield bonds. Historically, has that been a valid concern? No.
High yield bonds have actually performed better during periods of rising rates (9.2% annualized return) than falling rates (7.7% annualized return).
How is that possible? Well, high yield bonds have a shorter maturity and higher coupon than long-term treasuries and investment grade corporate bonds. As a result, they have a lower duration, meaning less sensitivity to rising rates. Additionally, when interest rates are rising, it can be a sign of an improving economy, and the price appreciation in junk bonds (spread tightening) can more than outweigh any negative impact from higher rates.
The Next 5 Years: Junk Bonds vs. Stocks
Now that we have a handle on how junk bonds behave, how should an investor think about their current risk/reward profile?
With a yield of around 5.5% (close to all-time lows), at the very least investors should be expecting below-average returns going forward. Beginning yield tends to be a decent predictor on that front. Generally speaking, the higher the starting yield the higher the prospective returns, and vice versa.
Given low current yields, hitting the 8.7% historical average return over the next five years would not only require a default-free environment but additional spread tightening as well. With spreads already at their lowest levels since 2007 that would be a lofty expectation, to say the least.
Does that mean investors today should prefer equities over junk bonds? Not necessarily. The tight credit spread environment and low prospective returns for junk bonds are not occurring in a vacuum. They are coinciding with a richly valued equity market that many argue will also lead to below-average forward returns.
What it comes down to, then, is what you believe is the most likely scenario going forward:
- If you believe that U.S. equity valuations will continue to expand (from already lofty levels) in the years to come, you are more likely to favor stocks.
- If instead you believe that equity valuations will mean revert in an upcoming bear market, you are more likely to favor junk bonds.
History supports such a view. Junk bonds have put on their best relative performance vs. stocks in the years following equity market peaks in 2000 and 2007. Conversely, their worst relative performance came during the late 1990s when U.S. equity valuations reached their most extreme levels in history.
From 1995 through 1999, junk bonds gained 60% versus an astounding 250% return for the S&P 500. The spread over the past five years (103% for stocks versus 36% for junk bonds) seems tame by comparison.
That said, the S&P 500 is on pace for its 9th consecutive up year, tying the record run from 1991-1999. Valuations are at their most elevated level in history with the exception of the dot-com bubble. It wouldn't be unreasonable for less risk-tolerant investors to be seeking out lower beta options in preparation for more difficult years ahead. High yield bonds have proven to be one such option over the past 30 years, displaying lower volatility, lower drawdowns, and significantly lower downside capture versus the broad equity market.
The trade-off in shifting some capital from equities to high yield?
Potentially missing out on further upside should equity valuations continue to expand. Junk bonds are still likely to be positive in such an environment but could significantly lag the returns from equities. Unfortunately, that's an unavoidable risk - for in order to protect capital on the downside, you have to be willing to give up some upside in return. There's no other way.