What Drives High-Yield Bonds (and Why You Should Listen to the Ratings Agencies)

Martin Fridson

High-yield bonds are attractively priced – or they aren’t – depending on how likely you think a double-dip recession is and how severe you think it might be.   If you think there is a greater than 21% chance that a severe economic downturn is ahead, you should avoid junk bonds.

What drives the high-yield market was the subject of a talk to the Boston Security Analysts Society last week by Martin Fridson, a global credit strategizst with BNP Paribas Asset Management who is a highly regarded expert on distressed debt.

The much-maligned ratings agencies are not as untrustworthy as you think, Fridson said, and their corporate bond ratings provide a reliable measure of default risk.

I’ll discuss why Fridson thinks Moody’s and S&P deserve a second chance, but first let’s look at the fundamentals of the high-yield market.

Default rates drive returns

Low default rates have consistently translated to strong performance for high-yield bonds in recent years, Fridson sad.  In 17 out of the last 23 years, default rates and returns (as measured by the Merrill Lynch high-yield index) have moved in the opposite direction.  “If you get the default rate right,” he said, “you probably have a pretty good idea of what is going to happen with returns.”

Fridson cautioned, however, that default rates don’t tell the whole story. The overall direction of interest rates and spreads to the Treasury market also play a role, he added, particularly in the short term. 

Once you make the decision to invest in the high-yield market, the critical choice is whether to invest in lower- or higher-quality bonds.  Fridson showed that there is an extremely close correlation between the tiers in the high-yield market and overall returns, as the figure below illustrates:

1989-2009

The vertical axis is the return differential between CCC bonds (the lowest-quality high-yield bonds) and BB bonds (the highest-quality).  The horizontal axis is the return on the overall high-yield market.  In both cases, the returns exclude income and represent price appreciation only, which Fridson said provides a clearer measure of the performance differential.   The slope of the line is almost exactly 1.0, suggesting that a percentage-point increase in performance in the overall market translates to a percent advantage in CCC bonds versus B bonds. 

In other words, if you forecast strong performance for high-yield bonds, you should overweight lower-quality credit.

The same relationship has existed between the performance of B-rated bonds and the high-yield index, which Fridson said is not surprising, because the average quality of the index is B.