High-Yield Bonds: Is the Juice Worth the Squeeze?
Examining the attractiveness of high-yield bonds.
12.16.2024
High-yield bonds, often called “junk bonds,” are similar to other types of bonds in that they represent loans taken out by companies that are funded by investors. In return, the companies promise to repay with interest.
What sets high-yield bonds apart is that the borrowing companies pay a higher rate of interest compared to investment-grade borrowers.
Why Do High-Yield Bonds Offer Higher Interest Rates?
Because they are considered riskier and have a greater likelihood of default.
Investors are drawn to high-yield bonds for their potential to deliver higher returns, but this comes with an increased risk of losing money. To compensate for the added risk, the companies must pay higher interest rates.
For example:
US Government Bonds: The US government has paid an average annual interest rate of approximately 2.4% for borrowing money over five years.
High-Yield Bonds: A riskier company might need to pay 7.3% annual interest over the same period.
The difference between these rates, known as the “spread,” is 4.9% in this example. This spread reflects the extra compensation investors demand for taking on greater risk.
The Impact of Market Conditions on Spreads
Spreads can widen or narrow depending on economic conditions and market sentiment:
During the Pandemic Shutdowns: Spreads surged to levels last seen during the Global Financial Crisis, as investors perceived a high risk of defaults and demanded higher compensation.
Post-Pandemic Boom: Spreads compressed to below 3% as default risk was viewed as minimal.
Current Market Conditions
Today, spreads on junk bonds are even lower, sitting at just 2.6%. This suggests the market isn’t expecting much default risk. While this low spread may indicate stability, it also limits the reward for investors taking on the risk of lending to lower-quality borrowers.
Is the Juice Worth the Squeeze?
In our view, the risk/reward tradeoff for high-yield bonds at current spread levels is unattractive. Lending to a low-quality borrower for a mere 2.6% premium over high-quality borrowers like the US government doesn’t justify the potential downside. The losses in the event of default could far outweigh the modest gains.
We continue to emphasize high-quality credits in our fixed-income strategies. While high-yield bonds may have their place in certain portfolios, the current environment offers little incentive to take on such risks.
So, is the juice worth the squeeze? For now, our answer is clear: No.
Disclosure: Unless stated otherwise, views, opinions or forecasts expressed in this blog are those of the author and do not necessarily reflect those of the Adviser and/or its employees. The contents of this blog are distributed for informational purposes, and are not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Nothing in these communications is intended to be or should be construed as individualized investment advice. All content is of a general nature and solely for educational, informational, and illustrative purposes.