Can High Yield Bonds Protect Your Portfolio in Down Markets?
When bond yields begin rising, it’s difficult to find places to hide. Since prices and yields move in opposite directions, rising yields mean falling prices – and falling principal value for your bond funds. Not all areas of the market respond to difficult conditions in the same way, however, and one – high yield bonds – has shown the ability to outperform during periods of weakness for the broader bond market.
Here are some examples, as compiled the Milken Institute:
Similar moves occurred in 1981, when yields rose from 12.43% to 13.98% and high yield returned 7.6%. More recently, high yield bonds were one the best performing segment of the market in the sell-off of that occurred in the second quarter of 2013. High yield outperformed investment-grade bonds in that interval, surprising some investors who thought that “higher quality” meant “safer.”
The year-by-year returns for high yield bonds from 1980 through 2013 can be found here.
While it’s somewhat counter-intuitive that one of the riskiest areas of the market can hold up well when yields in other market segments are rising, there are a number of reasons why high yield bonds can withstand these potentially adverse conditions:
There are different kinds of risk: While interest rate risk is the primary driver of U.S. Treasuries and many types of investment grade bonds, high yield bonds are affected more by credit risk - or the underlying health of the issuing corporation, which is turn affected by the economy and general business conditions. While broader rate movements can certainly influence the performance of high yield, credit risk plays a larger role.
What rising yields say about the economy: The role of credit risk is key, since rising yields in the Treasury market are often a sign that economic growth is improving. While this can hurt investment-grade bonds – since it may fuel higher inflation or prompt the Federal Reserve to raise interest rates – economic strength helps high yield by raising the odds that issuers will make all of their interest and principal payments on time. As a result, the performance of high yield bonds can diverge from market segments for which improving economic conditions don’t provide a tailwind.
The yield cushion: High yield bonds have a natural performance advantage from the outset by virtue of their superior yields. A bond yielding 7% per year can withstand a 4% price decline and still provide a positive total return, but the same can’t be said for a bond yielding 3%.
High yield follows stocks more than bonds: Over time, high yield bonds have had a much higher correlation with stocks than they have with bonds, since they share some of the same performance drivers that stocks have. Since stocks and bonds often move in opposite directions, so too can high yield diverge from the rest of the bond market.
A Caveat
In combination, these factors can help high yield bonds to perform well even when yields are rising, which make them one of the better options if bonds enter a bear market in the years ahead.
Still, it’s important to keep in mind that high yield bonds can indeed suffer when prevailing yields “spike” (i.e., rise very quickly in a short period of time). In this case, the resulting disruptions can lead to selling across the bond market, causing all segments to suffer regardless of their individual attributes. In an environment in which yields rise in a slow to moderate pace, however, high yield bonds will often emerge one of the strongest areas of the market.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.
When bond yields begin rising, it’s difficult to find places to hide. Since prices and yields move in opposite directions, rising yields mean falling prices – and falling principal value for your bond funds. Not all areas of the market respond to difficult conditions in the same way, however, and one – high yield bonds – has shown the ability to outperform during periods of weakness for the broader bond market.
Here are some examples, as compiled the Milken Institute:
- August 1986 - September 1987: High yield (HY) gained 10.6% as the 10-year yield went from 6.95% to 9.63%.
- September 1993 - November 1994: HY +1.8% as the 10-year rose from 5.4% to 7.9%.
- December 1995 - August 1996: HY +6.6% as the 10-year rose from 5.6% to 7.0%.
- September 1998 - January 2000: HY +5.2% as the 10-year rose from 4.4% to 6.7%.
- May 2003 - June 2006: HY +32.7% as the 10-year rose from 3.4% to 5.2%.
- December 2008 - December 2009: HY +69.3% as the 10-year rose from 2.3% to 3.9%.
Similar moves occurred in 1981, when yields rose from 12.43% to 13.98% and high yield returned 7.6%. More recently, high yield bonds were one the best performing segment of the market in the sell-off of that occurred in the second quarter of 2013. High yield outperformed investment-grade bonds in that interval, surprising some investors who thought that “higher quality” meant “safer.”
The year-by-year returns for high yield bonds from 1980 through 2013 can be found here.
While it’s somewhat counter-intuitive that one of the riskiest areas of the market can hold up well when yields in other market segments are rising, there are a number of reasons why high yield bonds can withstand these potentially adverse conditions:
There are different kinds of risk: While interest rate risk is the primary driver of U.S. Treasuries and many types of investment grade bonds, high yield bonds are affected more by credit risk - or the underlying health of the issuing corporation, which is turn affected by the economy and general business conditions. While broader rate movements can certainly influence the performance of high yield, credit risk plays a larger role.
What rising yields say about the economy: The role of credit risk is key, since rising yields in the Treasury market are often a sign that economic growth is improving. While this can hurt investment-grade bonds – since it may fuel higher inflation or prompt the Federal Reserve to raise interest rates – economic strength helps high yield by raising the odds that issuers will make all of their interest and principal payments on time. As a result, the performance of high yield bonds can diverge from market segments for which improving economic conditions don’t provide a tailwind.
The yield cushion: High yield bonds have a natural performance advantage from the outset by virtue of their superior yields. A bond yielding 7% per year can withstand a 4% price decline and still provide a positive total return, but the same can’t be said for a bond yielding 3%.
High yield follows stocks more than bonds: Over time, high yield bonds have had a much higher correlation with stocks than they have with bonds, since they share some of the same performance drivers that stocks have. Since stocks and bonds often move in opposite directions, so too can high yield diverge from the rest of the bond market.
A Caveat
In combination, these factors can help high yield bonds to perform well even when yields are rising, which make them one of the better options if bonds enter a bear market in the years ahead.
Still, it’s important to keep in mind that high yield bonds can indeed suffer when prevailing yields “spike” (i.e., rise very quickly in a short period of time). In this case, the resulting disruptions can lead to selling across the bond market, causing all segments to suffer regardless of their individual attributes. In an environment in which yields rise in a slow to moderate pace, however, high yield bonds will often emerge one of the strongest areas of the market.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.
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