Many investors shy away from high-yield bonds. The high yield bonds of heavily indebted companies are significantly riskier than safe government bonds. But if used correctly, high-yield bonds make a valuable contribution to the diversification of a portfolio.
Usually for the group of biggest companies, it is hard to imagine that they could ever go bankrupt. But today that no longer seems impossible. The bonds they issue are just junk in the eyes of the international rating agencies. Their creditworthiness has dropped below the mark that separates corporations with good credit from those with bad.
Because of the companies lack the “investment grade” rating, which is so important in the financial markets. Those who are denied this rating by the agencies are considered to be less creditworthy. Therefore, such companies have to pay higher interest. For this reason, bonds without an investment grade rating are called high-yield bonds. It is not uncommon for analysts and the media to refer to them as junk bonds , junk or rubbish bonds, because the default risk of these papers is higher than that of investment grade bonds.
HIGH-YIELD BONDS ARE WAY BETTER THAN THEIR REPUTATION
But the naming makes this niche market worse than it is. Between March 1999 and August 2020, high-yield bonds from companies in developed industrialized countries delivered 2 percentage points more return per year than exchange-traded index funds (ETF) on the MSCI World industrialized countries share index . At the same time, the fluctuations in the value of high-yield bonds were considerably lower.
Overall, corporate high yield bonds offered a better risk / return ratio than the MSCI World . Those who invested in high-yield bonds achieved a higher return per unit of risk. This applies not only to the entire study period, but also to the first two decades of the new millennium The mantra that has often been used in the past few years that stocks are “without an alternative” because fixed-income securities yield less and less interest is therefore not valid.
HIGH-YIELD BONDS – WHERE DOES THE RETURN COME FROM?
The majority of the income comes from high-yield bonds with the coupons . The issuers pay interest to the lenders annually on fixed dates. One source of additional gains and losses is price fluctuations. For example, if investors’ willingness to take risks increases, they pay higher prices for high-yield bonds and accept lower returns. On the other hand, increasing risk aversion, such as at the beginning of the corona pandemic, can lead to significant price losses (more on this below). In the case of international high-yield bonds, exchange rate fluctuations also have a significant impact on the price development. Overall, high-yield bonds are risky investments . Although they are safer than stocks, they are considerably more volatile than euro government bonds. This is why high-yield bonds belong on the risky side when putting together a portfolio. Anyone who swaps high-yield bonds for euro government bonds in order to increase the return on their portfolio also increases the risk significantly and usually lowers the risk-return ratio.
INVEST IN HIGH-YIELD BONDS
As with any asset class, there are different ways to invest. Investors can buy individual high-yield bonds or invest through actively managed funds and passive ETFs. Building an individual portfolio from individual bonds is time-consuming and expensive. In addition, many high-yield bonds are not affordable for private investors. Actively managed funds have the disadvantage that they are relatively expensive and most of them won’t beat the market in long term. In this respect, ETFs are also ideal for high-yield bonds.
DIFFERENCES IN HIGH-YIELD BOND ETFS
For most private investors, however, broadly diversified indices are the best choice, each one covering the entire market. In contrast to stocks, index providers but not base their high-yield bond indices on the country where the issuer is domiciled, but on the currency in which a company issues a bond. For example, the American TV provider Netflix has issued a high-yield bond in euros that is quoted in euro indices. As a rule, however, companies borrow money from the bond market in their home currency. For this reason, European companies are represented in the euro indices, while American companies are represented almost exclusively in the US dollar indices. There is also an ETF on a mixed global high-yield bonds index that relates to companies from industrialized countries. It may contain high yield bonds in US dollars, euros, British pounds sterling and Canadian dollars.
TRADING IN HIGH-YIELD BOND ETFS
Bonds are not a liquid asset class like stocks . They are usually not traded on stock exchanges but through banks. Only for a few bonds can buyers and sellers be found in the market at any given time. For investors, this means that there is no guarantee that they will be able to sell their bonds at a fair price at all times. This can be particularly difficult during stock market crashes . The latest example: The Corana crisis in March 2020. Back then, share prices fell faster than ever before. According to data from index provider MSCI , the difference between buying and selling price, the so-called spread , for high-yield bond ETFs skyrocketed from around 0.75 to 2.5 percent. At the same time, price uncertainty rose sharply. MSCI defines it as the difference between the highest and the lowest price for the same bond on different trading venues. In principle, the following applies: The less liquid the securities that an ETF tracks, the greater the likelihood that there will be differences between the ETF’s NAV and the market price in phases of high uncertainty on the stock exchanges. Investors should avoid trading in such market phases if possible. The article Buy ETF contains detailed background information on trading in ETFs.