Why Invest in High Yield Bonds?
High yield corporate bonds, are sub-investment grade bonds, utilised to access greater income opportunities for investors. Even though these bonds are not considered ‘investment grade’, many investors will be very familiar to companies’ issuing high yield bonds, including Ford, United Airlines, Block and News Corp.
Bonds are traditionally only accessible to institutional investors due to their large minimum upfront capital requirements of $500,000, and large increments thereafter. By investing in just one bond, it can create considerable amounts of concentration risk. Individual bonds also do not trade on an exchange and, depending on the particular corporate bond, can have low liquidity, making it difficult to exit when an investor may need to.
Thankfully, ETFs have solved some of these issues by making bonds easily accessible to everyday investors and by helping to instantly diversify across a range of bonds and bond maturities.
In the case of high yield, the Solactive USD High Yield Corporates Total Market Index, which the Global X USD High Yield Bond ETF tracks, measures high yield bonds issued in US dollars, holds over 1200 individual bonds, is issued from 430 companies across 9 sectors and is broadly diversified across 20 countries.
High yield bonds have a higher correlation to equities than investment grade bonds but they do offer some benefits that government and investment grade do not.
1. Credit and interest rate risk – How it plays a role
Investors seeking higher income from corporate bonds are typically required to choose between one of two risks.
- Credit risk – The higher the credit risk the more likely the company is to not pay back the debt (bond) often referred to as defaulting. The credit agencies in Moody’s, S&P and Fitch provide the ratings on the credit risk for each bond, hence why when investing in high yield bonds you are taking on more credit risk than in investment grade.Past performance is not a reliable indicator of future performance.
- Interest rate risk – This denotes change in interest rates and how this affects bonds prices. While high yield bonds take on more credit risk, they typically take on less interest rate risk than their investment grade peers. This is reflected in their lower duration, which is helpful in a rising interest rate environment.
This means that when interest rates rise, as they have in 2022, high yield bond ETFs can – perhaps counterintuitively – provide more capital stability, while also providing a higher yield than investment grade corporate bonds.
2. Potentially higher yields over other fixed income
There is a risk/reward pay off with US high yield bonds given you’re likely to receive larger yield potential than investment grade corporate and government bonds but take on more risk. For example, the Global X USD High Yield Corporates ETF is providing a yield to maturity of 7.8% as of 31 July 2022. This compares to the 4.2% provided by the Bloomberg US Corporate Bond Index and 3.7% on the Bloomberg US Aggregate Bond Index.
Source: Bloomberg. Data as of 30 June 2022. Past performance is not a reliable indicator of future performance.
High yield bonds see more of the payments received via coupons, and you will typically see bonds issued at shorter maturities in comparison to investment grade bonds that have larger payments at maturity. This leads to lower duration for high yield over investment grade.
- So, in the scenario when interest rates rise or are expected to, they tend to be less affected than investment grade bonds.
- The flip side of this is that when interest rates are falling, or are expected to, the prices of high yield are more likely to underperform investment grade bonds.
In the current setting, higher coupons have had a buffering effect on rising rates and falling bond prices as can be seen in the below chart.
3. Understanding high yield risk – Default rates are forecast to remain low
As discussed, a primary risk of investing in high yield bonds is the lower credit worthiness of issuers. However, we continue to see default rates for sub-investment grade borrowers being relatively low.
According to DWS Group, default rates could increase from historic lows. This could stem from bond issuers potentially being impacted by the slowing global economy and pressure from rising costs and supply chains issues. In saying that, the current one year default forecast as of July 2022 stands at 2.75%, which continues to remain below the 3.5% historical average for USD high yield bonds.
USHY: For those wishing to invest in high yield bonds, the Global X USD High Yield Bond (Currency Hedged) ETF (USHY) provides a solution. USHY invests in US dollar denominated bonds from global issuers on a currency hedge basis. The US dollar high yield bond market is the largest, most liquid and most diverse in the world. And as the high yield bond market is almost entirely over the counter, ETFs provide a useful access vehicle. In order to protect income streams from currency fluctuations, USHY uses currency hedging
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