An overview of high-yield bonds, and 2 Bronze-rated funds to access this asset class.
The corporate high-yield bond market is uniquely positioned at the crossroads of equity and fixed income. High-yield bonds are generally corporate bonds rated below BBB by S&P or Baa by Moody’s. A range of companies issues high-yield bonds, including casino operators, chemical companies, and financial-services firms. Companies may wind up with a high-leverage profile either intentionally (because of a leveraged buyout, leveraged acquisition, or recapitalization) or unintentionally (because of a deterioration of the underlying business of an erstwhile investment-grade firm).
Investors look to high-yield (or junk) bonds for income generation above what other fixed-income classes, like municipals and investment-grade corporate debt, can offer. Junk-rated issuers need to offer higher yields to entice and compensate lenders for the increased risk associated with their operations. High-yield bonds also provide diversification from other fixed-income asset classes. As interest rates rise, bond prices typically fall. However, high-yield bonds historically trade more in line with stocks than other bonds. In fact, over the past 10 years, high-yield bonds experienced a 0.77 correlation with large-cap stocks but a negative 0.03 correlation with core bonds, according to J.P. Morgan. Risk-averse investors and those relying on bonds for stability of principal and income should recognize the risks associated with this category and consider high-yield bonds only for a small portion of their portfolios.
High-yield bond funds have been on a tear over the past five years. As interest rates remained low, income-hungry investors flocked to this asset class looking for higher yields than offered by other fixed-income asset classes. The high-yield bond category (including open-end funds and passive investments) grew from a low of $80 billion in November 2008 to just under $300 billion through October 2013. After four straight years of net inflows, over the past year, flows have been a roller coaster. The category experienced a $2 billion net outflow over the past 12 months, but in the last month alone, more than $5 billion flowed back into high-yield funds and exchange-traded funds. Two primary factors drove these trends. First, an improving corporate backdrop and deleveraging of balance sheets lowered default rates for issuers of high-yield bonds. Second, a low-interest-rate environment caused some investors to swap low-yielding Treasuries and other securities for riskier high-yield bonds.
- source: Morningstar Analysts
Interestingly, while money flowed out of junk bond funds over the past 12 months, bank loans, a sister fixed-income investment to high-yield, gathered more than $63 billion in inflows. Bank loans are similar to high-yield bonds in terms of issuer credit quality, but they also feature variable interest rates and are backed by a specific asset. For more on bank loans, refer to previous articles here and here.
Despite a recent hiccup, this unprecedented demand for high-yield bonds has driven strong returns for the asset class. Over the past five years, high-yield bonds, as measured by the Bank of America Merrill Lynch High Yield Index, returned 18% annually, compared with 15% for the S&P 500 Index and 6% for the Barclays Aggregate Bond Index. It's not all roses and sunshine for junk bonds, however. In 2008, the high-yield bond category witnessed a drawdown of more than 32%. In the year to date, the average open-end high yield bond fund returned 6%, while similar closed-end funds returned 8.3%, as the leverage utilized by closed-end funds help generate higher returns (and risk).
Following this five-year run, investors would be prudent to question how much upside remains in high-yield bonds. This article won’t answer that question; both bulls and bears make valid arguments regarding future returns of this asset class. Bulls argue that default rates just over 1% remain near all-time lows compared with historical average of 4.2%. Following the 2008 financial collapse, high-yield issuers maintained healthy cash flows and improved balance sheets. Further, many believe that rising rates will occur in tandem with an improving economic backdrop. In this case, improving fundamentals should lower credit risk in high-yield bonds via even lower issuer default rates. And, while rising rates will drive fixed-income portfolio values lower, high-yield bonds offer some shelter from dramatically falling prices. Finally, while the current option-adjust spread (the difference between interest rates on Treasuries and junk bonds) of 4.3% as of Nov. 20, 2013, is below the historical average of 5.9%, it is still well above all-time low of 2.4% reached in June 2007. This indicates bond prices could benefit from further spread narrowing.
On the flip side, bears argue that yields are low on an absolute basis so investors aren’t getting paid enough to assume the risk associated with high-yield bonds. And while portfolio managers point to the low spreads achieved pre-financial crisis as indication of more upside, others would argue that current spreads indicate a frothy market. Many portfolio managers have also begun to notice easing credit standards and recent issuances of “covenant-lite” bonds which place little-to-few restrictions on high-yield issuers and offer less security for investors.
High-Yield Funds We Like
Investors who believe the bull case for junk bonds have several options to gain access to high-yield bonds. Perhaps the easiest method is via an ETF like iShares iBoxx $ High Yield Corporate Bond HYG.
For those seeking actively managed options, BlackRock High Yield Bond BHYAX and BlackRock Corporate High Yield HYT are two Bronze-rated high-yield bond funds that provide investors access to a strong management team that focuses on fundamental analysis and risk control. Both funds are led by BlackRock’s head of leveraged finance, James Keenan, and follow similar processes and investment holdings, but with some stark differences too.
Keenan works with a team of 35-plus analysts and sector portfolio managers to generate investment ideas. The team employs a bottom-up approach, focusing on firms with strong management teams, pricing power, and ample free cash flow to reduce debt. Risk control is paramount, and a risk committee regularly reviews the BlackRock’s holdings to understand where it may be taking on too much risk in terms of macro-level correlations, weightings to industries and individual securities, as well as overall beta of the portfolio. While Keenan has yet to navigate this fund through a severe downturn (he took over in May 2009, after the fund’s punishing 2008 plunge), we like the team’s fundamental approach to managing the portfolio.
As a closed-end fund, the Corporate High Yield fund employs leverage that will amplify total returns over its open-end counterpart. (For more background on the nuances of closed-end funds, check out the Morningstar Closed-End Funds Solutions Center.) The table below illustrates how leverage can help returns during up markets, but also hurt results in downturns such as 2008.
- source: Morningstar Analysts
Leverage at the closed-end fund has been steady for the past year but has fluctuated over time. For example, leverage ratios floated around 1.30 through most of 2011 and dipped as low as 1.21 in 2010 and during the 2008 financial crisis. In order to gain additional leverage, as well as for speculative purposes, the fund invests in swaps, currency exchanges, and other derivative investments. The leverage utilized also helps the closed-end version maintain higher distribution rates near 8.2% at share price compared with 5.75% with the open-end fund. Another sweetener at the closed-end counterpart is the 9.2% discount that its shares currently trade at, compared with a three-year average discount of only 1.5%. Any narrowing of the gap between share price and net asset value would juice returns compared with the index even further.
Both these funds make valid options for those willing to assume the risk associated with high-yield bonds. Investors also need to recognize the added layer of risk and volatility associated with the leveraged closed-end fund. You can see the full list of all Morningstar’s closed-end funds with Analyst Ratings of Bronze or higher here.