FINANCIAL TOOL
High Yield Bonds
When smaller, unproven companies accept loans through the sale of bonds, investors require a higher payout because of the higher risk of default.
These bonds are below investment grade (BB+ and under) and pay a significant premium above the risk-free Treasury rate.
When markets are doing well and investors are optimistic, this premium might be less. For example, investors might only require 2.5% above the Treasury yield if they think the risk of default is lower.
But when markets are full of uncertainty, investors may turn pessimistic and perceive the risk of default as being higher. In this case, they might require something like 5% or more above the Treasury yield.
This difference between the Treasury yield and the bond yield is called the yield spread.
The spread narrows during good markets and widens during volatile markets.
This happens for investment grade bonds as well, but in a much less dramatic fashion, because their spread range is much narrower.
What does this mean for your portfolio?
This means that high yield bond prices act more similarly to stock than to bonds.
Here’s why.
When stock returns improve, the yield spread narrows. This means newly issued high-yield bonds don’t have to pay quite as high a premium above the risk-free rate. So, if you own a high yield bond paying 10%, and suddenly similar bonds are being issued to pay only 8%, then you can sell your bond for a higher value.
Just like any other bond, there is an inverse relationship between interest rates and bond prices.
But high yield bonds depend mainly on investors’ perception of default risk, meaning the bond price often goes up when stocks are up and down when stocks are down. This might even be regardless of whether the US Treasury rate has changed at all.
Investment grade bonds, on the other hand, depend more on what US Treasury rates do or are expected to do. So when stocks are down, investment grade bonds, most of the time, tend to be up except in rare circumstances like 2022.
So where do high yield bonds fit in a portfolio?
Well, it’s not usually smart to just hold one or two. If you choose to hold any at all, a fund of high yield bonds is going to be important to diversify the risk. But they’re usually best kept as a small portion of the overall portfolio.
They don’t offer as much diversification from stocks as investment grade bonds do, and yet they don’t offer full stock-like returns either. It’s almost like a hybrid risk/reward ratio between that of bonds and that of stocks. It occupies the middle ground.
So high yield bonds can be an important part of a total portfolio. If you’re more of a risk-seeker, these might be used as part of your bond allocation. If you’re more conservative, you may choose to avoid these or keep them to a bare minimum.