Are High-Yield Bonds a Good Bet Right Now?

Generally, the bond portion of a portfolio exists to balance the risks and volatility of the stock portion. Bonds have historically had lower volatility and a low correlation to stocks.

Not all bonds are high quality. High yield or junk bonds represent debt issued by corporations with a below investment grade rating. In the low interest rate, low yield environment of the past decade investors and financial advisors have had to look for yield in places other than traditional investment grade bonds. High-yield bonds, generally purchased via a mutual fund or exchange-traded fund, have been one alternative for many investors.

With the recent problems with the Third Avenue Focused Credit Investor (TFCVX) and other concerns are high-yield bonds a good bet right now? (For more, see: Why Junk Bonds Are Aptly Named Right Now.)

According to Morningstar, Inc., over the past five years the SPDR S&P 500 ETF (SPY) and the ishares Core US Aggregate Bond ETF (AGG) which tracks the Barclay’s Aggregate Bond Index have a correlation of -0.16. This means the there is little correlation between the price movements of these ETFs and that the correlation is slightly negative.

By contrast the ishares iBoxx High Yield Corporate Bond ETF (HYG) has a correlation to SPY of 0.76, which says that there is a 76% relationship between the price movement of the two ETFs.

The core bond ETF and the high yield bond ETF have a low correlation of 0.17 meaning the correlation is slightly positive. This means there is little correlation in the price movement of the two ETFs and this is a good proxy for correlation of the two asset classes. (For more, see: Junk Bonds: Everything You Need to Know.)

To the extent that one believes that stock prices are headed for a fall then by this measure high-yield bonds could be in trouble.

Junk bonds have been in the news of late with the closure of the Third Avenue fund as they prepare to do an orderly liquidation, but in reality most of the issues in this fund and with junk bonds a whole are focused on issuers in the energy and commodities sectors.

According to a recent piece by CNBC, defaults on high-yield bonds were running at about 2.7% for the first 10 months of 2015 and are projected to run at about 3% in 2016. Both figures are below the long-term average of 4.6%. (For more, see: Are High-Yield Bonds Too Risky?)

Despite the word “bonds” in their name, high-yield bonds are not the volatility reducing asset that you might associate with an investment grade bond fund. A look at the returns of the three ETFs for the calendar year 2008 is revealing:

• SPY:  -36.81%
• AGG:  7.57%                      
• HYG:  -17.58%

While high yield bonds did “better” than stocks during this year of the financial meltdown, they were not the safe haven that core bonds proved to be. 

Looking at the trailing five-year returns (as of Nov. 30, 2015) and the volatility of these ETFs as measured by their standard deviation of return:

• SPY:  14.29% return; +/-11.87% standard deviation of return
• AGG: 3.03% return; +/-2.79% standard deviation of return
• HYG:  5.06% return; +/-6.86% standard deviation of return

This says that over this period of time high-yield bonds have provided a return that is better than core bonds and lower than stocks. The average return of HYG is about 35% of what SPY provided with about 58% of the variability of return. The core bond ETF provided about 60% of the return of high-yield bond ETF with about 41% of the volatility.

While none of these numbers are either definitive or predictive of anything, it's safe to say the high-yield bonds exhibit some traits of both stocks and bonds, but as discussed earlier they have a higher correlation to stocks than to core bonds. (For more, see: Is the Party Over for Junk Bonds?)

In my opinion, and other investors and financial advisors might well disagree, high-yield bonds can have a place in a diversified portfolio. The allocation probably shouldn’t be a large one as high yield really doesn’t exhibit the traits of an asset class that one might normally use for diversification away from stocks. (For more, see: 4 High Yielding Junk Bond ETFs.)

However, the low correlation to core bonds does present an opportunity in this period of the Fed’s initial rate hike. The low correlation to core bonds makes sense in that one wouldn’t expect high-yield bonds to be as sensitive to a rate hike since their coupon rates are already high. (For more, see: Top 3 High-Yield Bond Mutual Funds.)

Schwab fixed-income analyst Kathy Jones, told CNBC, “High-yield bonds often perform better in such a climate, though we are still cautious about stretching for yield."

For long-term investors and financial advisors who counsel them, high-yield bonds should be viewed in terms of where they fit into a portfolio. The consensus view seems to be that this is not a particularly opportune time to get into high yield, nor is some of the recent weakness a signal of a crises here either. As opposed to interest rate movements, high-yield bonds are far more impacted by factors that might cause the issuers to default and investors should be alert to signs in the economy that might increase default rates. (For more, see: Will the High Times in High Yield Continue?)