None other than Gluskin Sheff’s Dave Rosenberg, the widely followed analyst who was been consistently bearish in the current market cycle, said last week that high-yield (HY) bonds are “a good place to be right now.”  Recent price declines have made them attractive in the short term, and their risk-adjusted returns make them attractive to longer-term strategic investors.

From 1978 through 2010, HY bonds delivered an average annual return of 11.1% with volatility of 15.3%, comparable to the volatility of the S&P 500 (15.5%).  The HY sector provides the best features of both equities and bonds: substantial long-term average annual returns combined with bond-like performance in periods when bonds dominate.  Vanguard’s long-running HY bond fund (VWEHX, expense ratio = 0.25%), has delivered annual returns of 6.2% over the past 10 years, while the U.S. aggregate bond index, in contrast, has delivered 5.8% and VWEHX has current yield above 7%. 

Illustrating the opportunity created by short-term price declines, Rosenberg published the following on August 29:

Huge Spike in Corporate Debt Yields

Corporate bonds rated below investment grade are considered high yield.  These bonds are considered riskier because the ratings agencies project they are more likely to default and, if they do, their recovery rates will be lower than those of investment-grade bonds. 

High-yield bonds have an interesting history that is popularly associated with scandal (e.g., Mike Milken).  Many investors assume these bonds are risky and speculative, but the long-term data now available for this asset class suggest otherwise.  The market for HY debt has grown dramatically in the last 20 years, from $150 billion in 1990 to over $1 trillion in 2010.  In addition, the emergence of the options markets for HY bond ETFs provides greatly increased transparency.  HY bonds are risky, but the risk levels are well within the range of other asset classes used in asset allocations for individual investors. 

Many investors do not understand HY bonds well, unfortunately.  I will explore key features of the HY bond market and why HY bonds are an important asset class for strategic asset allocation. 

High-yield bonds offer attractive risk-adjusted returns

A central paradigm driving the bond markets is that yield is a proxy for risk.  Bonds that are riskier will need to pay higher yields to entice investors to bear that risk.  There are two primary sources of risk for bondholders.  The first source of risk is interest rate risk.  For bondholders, increased rates reduce the future value of the repayments they will receive from the issuer.  The second source of risk is default risk, the risk that the issuer cannot make the payments on its debt. 

While most investors consider yield to be an indicator of risk, the emergence of options on ETFs allows for a direct measurement of risk.  This development, which occurred over the last four years, marks a major shift for advisors and investors.  It used to be difficult to assess the risk levels associated with a class of bonds.  For individual bonds, one could look at the ratings.  For a portfolio of bonds (in the form of a mutual fund, for example), one could look at the range of ratings of bonds held in the portfolio.  Conversely, one could look at the trailing historical volatility of the total returns from a bond fund.  Both of these approaches had value, but neither provided a direct measure of forward-looking risk.