The fixed income world has evolved over the years, with new products and vernacular that can be foreign to the most experienced investors. But even well-established asset classes have their own nuances. Consider, for example, high yield bonds.
High yield bonds are issued by companies judged to be at higher risk of defaulting on debt payments than issuers of investment-grade credits. In return for higher default risk, investors expect to be compensated with higher yields. But not all high yield issuers present the same credit risk. There are, in fact, meaningful differences between the various quality sleeves that comprise the high yield market.
What makes up the high yield universe?
Bonds are graded by ratings agencies, including Standard & Poor’s (S&P) and Moody’s Investors Service (Moody’s) . Bonds rated above BB (S&P) and Ba (Moody’s) are considered investment grade. S&P rates the high yield universe on a scale from BB to D, and Moody’s on a scale from Ba to C.1
And that’s where the nuance lies.
Moody’s rates high yield bonds by their estimated credit risk, while S&P assigns ratings according to an issuer’s vulnerability to non-payment: “Less vulnerable,” “more vulnerable” or simply “vulnerable.” These may not seem like big differences, but this quality dispersion can help or hurt your quarterly statements depending on market conditions.
High yield performance has varied
Consider the performance of high yield bonds thus far in 2015. The benchmark BofA Merrill Lynch U.S. High Yield Index has returned 0.13% year-to-date through Oct. 31.2 But dig a little deeper and the story gets more interesting.
BofA Merrill Lynch U.S. High Yield Index returns by credit type
Through Oct. 31, higher-quality BB credits are up 2.38%, while debt with a B rating is off 0.14% on the year. Now look at the lowest tier. Bonds rated CCC and below are down a whopping 6.16%.1 This lowest-quality credit sleeve has clearly dragged down the high yield market as a whole.
Commodity and basic materials issuers were a major driver of high yield underperformance during the first three quarters. West Texas Intermediate crude oil prices plunged 24% in the third quarter alone to $46 per barrel, while the S&P 500 Materials Index fell nearly 18% in the third quarter.3 This is significant, as energy and materials issuers are major components of the high yield market. Sector-specific weakness, combined with global concerns and weak corporate earnings, have caused yield spreads (the spread between US Treasury yields and corporate bonds of similar maturity) to widen – a sure sign of a flight to quality.
High yield investors have options
Fortunately, you have a choice when it comes to high yield investing. The PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB) seeks to track the RAFI Bonds US High Yield 1-10 Index, which invests in only credits rated B3 and above by Moody’s and B- and above by S&P. That means investors are exposed to the higher-quality segment of the high yield market. These are bonds viewed as having less default risk that have the potential to outperform during periods of volatility and widening credit spreads – the very conditions we’ve witnessed in recent months. (Of course, there are other times when lower-rated credits will outperform.)
PHB emphasizes the higher quality range of the high yield universe
And unlike traditional issue-weighted ETFs, which weight according to a company’s indebtedness, PHB is a smart beta fund. In this case, that means it adheres to a rules-based methodology that weights credits according to company fundamentals – not debt size. PHB is rebalanced quarterly and reconstituted annually, potentially preventing it from amassing company and sector biases that can bog down performance over time.
1 A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality. For more information on Standard and Poor’s rating methodology, please visit www.standardandpoors.com and select ‘Understanding Ratings’ under Rating Resources on the homepage. For more information on Moody’s rating methodology, please visit www.moodys.com and select ‘Rating Methodologies’ under Research and Ratings on the homepage.
2 Bloomberg L.P, Nov. 5, 2015
3 Federal Reserve Bank of Dallas, Third Quarter 2015
Important information
Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.
Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments.
Smart beta represents an alternative and selection index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both, in active or passive vehicles. Smart beta funds may underperform cap-weighted benchmarks and increase portfolio risk.
The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar-denominated, below-investment-grade corporate debt publicly issued in the US domestic market.
The S&P 500® Materials Index comprises those companies included in the S&P 500 that are classified as members of the GICS® materials sector.
The RAFI Bonds US High Yield 1–10 Index is comprised of US dollar-denominated bonds which are SEC-registered and whose issuers are public companies listed on a major US stock exchange. Only investible, non-convertible, non-exchangeable, non-zero, fixed coupon high yield corporate bonds qualify for inclusion in the index. No foreign agencies, governments or supra-nationals are allowed.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods. Due to anticipated Federal Reserve Board policy changes, there is a risk that interest rates will rise in the near future.
Investments focused in a particular industry are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.