High-Yield Bonds: A Short-Term and Long-Term Perspective

From pension funds that invest in 100-year bonds to individuals who focus on earning monthly income, different types of investors have various investment horizons. This blog discusses the prospect of investing in high-yield corporate bonds from both a short-term and long-term perspective.

The idea of investing in high-yield bonds has become more mainstream, especially with the rise of multiple high-yield bond exchange traded funds (ETFs). These ETFs mitigate idiosyncratic (i.e. issuer-specific) risk by providing investors with low-cost exposure to well-diversified baskets of high-yield bonds. For illustrative purposes, this blog examines the Bloomberg Barclays US Corporate High Yield Total Return Index (High-Yield Index). DWS’s forecasts imply that there is a positive short-term outlook for investing in the High-Yield Index, and in the long-term, investors who are concerned about lofty asset valuations and impending volatility may take comfort in the resiliency that the High-Yield Index exhibited through the worst financial crisis in recent memory.

Short-term approach:

What can investors who have a short-term (i.e. one year or less) view expect to earn from high-yield bonds today? To answer this question we need to discuss our expectations for some of the main factors that affect bond returns, namely: roll-down return, carry, and price return due to changes in interest rates and spreads.

Roll-down return characterizes the return that investors receive as bonds age and “roll” along the yield curve. To minimize complexity, we will not quantify roll-down return but instead note that it is positive in today’s upward-sloping yield curve environment.

Carry is the next component of return. For simplicity, we use yield to worst (YTW) as a proxy for carry on the High-Yield Index. The approximate carry that investors should expect to earn on the High-Yield Index is its current YTW of about 6.5%.

Price return is affected by duration and the path that interest rates and spreads take. The High-Yield Index has an option-adjusted duration of about 3.9, which means that for a 1% increase (decrease) in yield, price is expected to decrease (increase) by about 3.9%. DWS’s next twelve month forecasts (as of September 2018) imply that interest rates and spreads will deviate from their current levels. The table below summarizes our view:

Interest Rate or Spread Current Levels3 Firm Forecast Implied Change from Current Level
2-year treasury 2.90% 3.00% 0.10%
10-year treasury 3.24% 3.25% 0.01%
3.9-year equivalent maturity treasury1 2.98% 3.06% 0.08%
High Yield Spread2 3.31% 3.70% 0.39%

1. Using linear interpolation, we estimate an interest rate that the firm’s forecasts would imply for a 3.86-year equivalent maturity treasury.
2. Bloomberg Barclays US Corporate High Yield Average Option Adjusted Spread (Source: Bloomberg).
3. Current levels are approximate as of 10/10/2018 (Source: Bloomberg ).

DWS’s forecasts imply about 39 basis points (bps) of widening spreads and 8 bps of rising interest rates at the 3.9 year maturity (which matches the duration of the High-Yield Index). Widening spreads and rising interest rates have a negative effect on bond prices. Taking into account the duration of the High-Yield Index, the change in spreads and interest rates implied by DWS’s forecasts indicate that price movements should have an effect of about -1.8% on index returns.

Summing our estimates for carry and price return, our view is that investors could potentially expect to earn about 4.7% (i.e. 6.5% – 1.8% = 4.7%) on high-yield bonds over the next twelve months, and this estimate does not account for positive roll-down return that investors should also receive. Therefore, in today’s still-low interest rate environment, high-yield bonds may be attractive for yield-seeking investors.

Long-term approach:

In the long-term, the focus shifts to risk-adjusted return, as near-term price fluctuations due to volatility in spreads and rates become less important. Consequently, the decision on whether to invest in the High-Yield Index is best influenced by examining its historical performance.

According to a Deutsche Bank default study from April 2016, during the financial crisis the maximum default rate of high-yield credits did not exceed 14%. Commensurately, high-yield bond indices declined by no more than 33% before they began to recover. How did these declines affect long-term investors who bought high-yield bond ETFs prior to the financial crisis? To get a sense for the answer to this question we can look at the total return of the High-Yield Index and compare it to the total return of the stock market over a ten year time frame that includes the financial crisis (i.e. August 2007 to August 2017).