Tuesday 04 April 2017 by Opinion

Income with stability – High yield bonds

We talk a lot about high yield bonds, but how well do you understand how they fit into a portfolio? 


Investing in companies – two options, same company

The starting point is to understand what you are investing in.  A high yield corporate bond, just like any other bond, is a legal obligation.  It is an obligation of that company to pay the holder of the bond (the investor) regular interest payments and the principal at maturity, typically a fixed amount of $100 per bond. The company must pay those interest payments and the principal before shareholders receive anything.

Corporate bonds are lower risk than equities in the same company and offer lower returns because they are a legal obligation. Further, in the event of a wind up, bondholders are due to be repaid before equity investors. Bonds sit higher in the capital structure, as shown in Figure 1.

Figure 1
Source: FIIG Securities

Little if any upside from corporate bonds

The strongest argument for owning equities is that they are a growth investment – whereas bonds, other than if you trade them for a profit, are a nil growth/all income investment.  Almost every investor needs growth in their portfolio, so equities almost always play an important role. 

More downside from equities

Conversely, as corporate bonds are an obligation of the company, when investors get nervous such as in a market correction, share prices tend to fall further than corporate bond prices. For example, in the 2000 equities market correction, equity markets peaked on 9 January 2000 and then declined 47% by February 2002, 25 months later. High yield corporate bonds started their fall later in March 2001, and fell 13.1% over 19 months. 

Equities take longer to recover

During that same correction, equities took four years to recover (2006) while high yield corporate bonds took just five months (2003). 

In the largest correction on record – the GFC – high yield corporate bonds fell 35% in 19 months from May 2007 to December 2008, but again took just eight months to recover (April 2009).  Equities, on the other hand, fell 55% from October 2007 to January 2009 but took 37 months to recover (February 2012).

High yield corporate bonds are a blend of equity risk and bond risk

All bonds – whether corporate bonds or otherwise – have an inverse relationship between credit spread and their price. Unlike government bonds, corporate bonds are driven by two market yields – the risk free government bond yield and the margin the market demands for the corporate risk, known as “credit spread”. The credit spread is highly correlated to equity market moves. When equity markets are falling, investors demand more credit spread, and vice versa. 

For example, if high yield Sunland 2020 bonds are paying 6.21% yield to worst, the market prices that bond by looking at what the risk free (government) yield is for the same maturity (currently 1.70%) and then considers the 4.51% difference (6.21% less 1.70%) as the “credit spread” or the margin paid for the corporate risk of Sunland. This is illustrated in Figure 2.

Figure 2
Source: FIIG Securities
Credit spread yield to worst accurate as of 4 April 2017 but subject to change
All bonds listed are senior debt

Here’s where the hedge comes in. In the event that equity markets fall sharply, credit spreads typically rise as the market demands more margin for the corporate risk.  All other things being equal, this would push the price of any given corporate bond downwards.  However, when equity markets fall, typically government bond yields will fall too, meaning the price of government bonds will rise. Therefore, one part of the high yield corporate bond has declined in value (the credit spread part) but the other has risen (the risk free bond part). 

Where the credit spread component is larger than the risk free component, as shown in the Qantas example, a corporate bond will still fall in value, but its decline will be greatly hedged by the risk free component. In fact, for lower risk corporate bonds, that is investment grade corporate bonds such as the senior bonds of ANZ, the credit spread is much smaller, so the value tends to rise in a falling equity market as the risk free component outweighs the credit spread component. 

Confused? Let’s try that in numbers

As shown in Figure 3, in almost all of the major rises or falls in bond yields over the past 15 years, credit spreads have moved in the opposite direction.  The major exceptions were the bull market days of 2006 when the Federal Reserve was slow in applying the brakes to the overheating US economy, but the credit market had already started to demand more margin; and 2010 when Quantitative Easing distorted normal relationships. In each other market, you can see how the inverse relationship between bond yields and credit spreads would have created a hedge which reduces the change in the yield – and therefore the price – of a high yield corporate bond.

Largest bond yield movements – past 15 years

Figure 3
Source: Federal Reserve Economic Database 


Companies use both corporate bonds and equities for funding operations and interest and dividends are paid from company earnings. Corporate bondholders must be paid from gross earnings prior to any dividends, and their capital must be repaid at maturity. In contrast, equity holders have no legal rights to any payments, but own the balance of the company once all debtors are paid out. 

The risk that shareholders face is that the company doesn’t increase earnings enough to pay debtors off and have some left over for shareholders.  The risk that corporate bondholders face is the risk that the company doesn’t even earn enough to pay bondholders. 

Ultimately, both investments represent an exposure to the same part of the economy – the corporate sector.

As shown in this paper, high yield corporate bonds tend to perform like a mix of equities and bonds. Risk is buffered by the offsetting movements in bond yields that typically occur in such environments.