Thursday, 5 August 2010

High Yield Bonds - Take a Chance on Them?

In love, hope springs eternal. Abba's classic song Take a Chance on Me expresses the timeless desire that a future romance need not be like the disappointments of the past.

Hope springs eternal in investing too. The recent news in the National Post of Air Canada's issuance of a large dollop of debt at high interest rates ranging from 9.5% to 13% may have raised investor interest given the paltry rates available from GICs and government debt. The main attraction of such bonds is the high return but there is a catch. Air Canada has let investors down in the past - its 2003 bankruptcy.

The Globe and Mail reports a rekindling of interest in high-yield debt in Canada. Should we investors look at such high-yield bonds and Take a Chance on Them?

What is High Yield Debt?
High-yield bonds, also called junk bonds, are those rated below Baa3 by credit rating services Moody’s, BBB- by Standard & Poor’s and BB(high) by DBRS. PIMCO's Bond Basics provides a good overview of high-yield bond characteristics.

Credit / Default Risk
The higher probability that companies (or governments) will default on their debt and not pay investors the interest promised or part or all of the principal is the key factor driving the juicy interest rates on offer. Default happens constantly even in good economic conditions but the rate jumps up orders of magnitude in recessions. This 2004 slide presentation by NYU professor Dr. Edward Altman showed how US corporate annual default rates since 1971 varied from a low of 0.16% in good times to a high of 12.8% in recessions. 2009 has followed the recessionary pattern according to Bloomberg as default rates on high-yield class companies rose to a peak of 9.8% on a global scale and 9.5% in the USA. But conditions have been improving and default rates have declined a few percent already with forecasts predicting a rate of about 2% by year end.

The default rate is critical since such losses comes straight off the top of the yield for a fund holding a number of bonds. For instance, if the combined average yield of a fund is 10% and the default rate is 8%, the fund's net return is only 2%. When markets / investors get worried about default rates, even before actual default rates begin to rise, the price of bonds and the fund will fall accordingly to compensate. For new investors, that is fine, the new lower price is protection for what is expected but an existing investor who bought in a while back experiences negative returns. High-yield bond fund prices and returns can thus be extremely volatile.
The difference between the average yield on bonds in a high-yield fund and investor returns from holding the fund can be seen in figures for the ETF iShares iBoxx $ High Yield Corporate Bond Fund which holds US bonds (symbol: HYG). The average yield to maturity of bond holdings is 8.35%. At the same time, the total 3-year return is only 3.54% and the 1-year return is 21.5% due to the combined effect of price changes and defaults.

Possible Diversification Benefits
There is an argument made, e.g. by PH&N in The Case for Investing in High Yield Bonds and BMO's Diversify Your Fixed Income with High Yield Bonds that high yield bonds may behave in different patterns than other asset classes and thus provide a diversification benefit in a portfolio that is regularly rebalanced.

How to invest in high-yield debt
The sensible way for individual investors to buy high-yield debt, unless there is a willingness to take on the even greater risk of seeing the individual company become one of the defaulters and possibly losing everything, is to diversify by investing in a high-yield sector mutual fund or ETF (e.g. HYG has 351 holdings). If you really want to buy high-yield bonds of an individual company from an online broker, you would need to phone the bond desk since the bonds listed online consist only of investment grade rated bonds.

Most of the holdings in funds are bonds of US corporations, simply because there has been relatively little issuance of such bonds in Canada in recent years, though the Globe article cited above mentions a big rise in activity recently.

Canadian-traded - Both ETFs below eliminate the foreign exchange risk by hedging the US dollars of the holdings to Canadian dollars (though this comes at a cost and will reduce returns). The ETFs passively track an index, though each follows a different one.
US-traded - Stock Encyclopedia's Bond ETF list includes the following high-yield funds. All trade in US dollars, which means a Canadian investor is exposed to currency shifts as well as bond-specific factors.
Mutual Funds - All mutual funds available to Canadian investors come from Canadian providers since US-based mutual funds may not be sold in Canada. A search using GlobeInvestor's Fund Filter with High-Yield Fixed Income set as the asset class turned up 138 funds. MERs range from 0.87% to 3.25%. Most such mutual funds employ an active management strategy in an attempt to obtain even better returns but, as usual, the result is that there is a huge range of performance - 1-year returns range from 5.8% to 45.5%.

Whether or not to buy in
Is the time right and will default rates continue to fall, or will the double dip recession be upon us to wipe out the higher yield through persistent high default rates? As with love, so it is with high-yield debt. To take the chance or not? If you do, there is a chance you may suffer a broken heart, but if you do not, you cannot find happiness. We must make our own choices.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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