The high-yield bond market has been affected by COVID-19. Yields have surged due to economic uncertainty. But these bonds hold more risk than investment-grade issues. How do investors decide if they should add them to their portfolio?
Investors looking to add bonds to their portfolios face a trade-off: The safest government bonds currently pay very low yields, while higher-yielding corporate bonds are more prone to default. In the current low interest rate environment, how can investors decide which types of bonds to add to their portfolios?
As a rule, high-yield corporate bonds may come with more risk. On the other end of the spectrum are U.S. Treasury bonds, which are considered one of the safest investments around.
Three popular types of bonds include corporate, municipal, and Treasury. Of the three, high-yield corporate bonds represent the most aggressive investment and Treasury bonds the least.
The difference in the credit quality of the bond issuers certainly plays a role, but other factors can impact bond yields as well. A high-yield bond issuer is typically a company that doesn’t have as strong of a track record, or such strong financials, as one that can issue a bond that’s investment grade. Investment grade is BBB or above, as rated by Standard & Poor’s.
“COVID-19 has produced some very challenging times for investors recently,” said Perry Guarracino, director, fixed income at TD Ameritrade. “The difference in investment-grade bonds versus below investment grade becomes more obvious during times of extreme market volatility. Unlike Treasury bonds, which are backed by the full faith and credit of the United States government, investors need to do their research when purchasing corporate or municipal bonds.”
Ten-year U.S. Treasury bonds pay around 0.64% based on the 10-year Treasury Yield Index (TNX). Municipalities also issue bonds, and their yield depends on finances at the local level. One advantage of municipals is that they’re usually tax free. Corporations issue bonds as well, and their yield depends on the perceived quality of the company. The better the company’s perceived financials, the lower the rate at which it can borrow, and consequently the lower the yield.
“During times of extreme market volatility and uncertainty, investment-grade bonds can quickly fall below investment grade, and their value can fall dramatically, which is why it’s important to know what you’re buying,” Guarracino commented.
But it’s difficult to know for sure which corporations or municipalities can weather the storm and come out of the current market in good shape to proceed. So how can investors decide which bonds to invest in? “For municipals, I might concentrate on state general-obligation credits or essential service bonds like water and utilities. I might stay away from credits that’re tied to revenues like airports, hospitals, nursing homes, and so on that’ll struggle to recover post-pandemic,” Guarracino explained. “On the corporate bond side, I might stay away from large retail department stores that might not survive moving forward and instead look at credits that are well rated and have held up well.”
High-yield corporate bond prices dropped in early 2020, and their average yields rose to levels not seen since September 2009. High-yield value is measured by the yields’ relationship to Treasury yield. For instance, if high-yield bonds yield 8% and Treasury bonds yield 2%, the difference is 6%, or 600 basis points. The greater the difference, the more enticing high-yield bonds become.
After reaching a low in January 2020, the spread between high-yield corporate bonds and Treasury yields spiked in March due to the continuing uncertainty from COVID-19. It has since pulled back and is trading close to 700 basis points (see figure 1).
FIGURE 1: RISING SPREADS. The spread between Treasury yields and high-yield corporate bonds spiked in early 2020 due to the uncertainty surrounding COVID-19. Data source: Federal Reserve FRED database. FRED® is a registered trademark of the Federal Reserve Bank of St. Louis. The Federal Reserve Bank of St. Louis does not sponsor or endorse and is not affiliated with TD Ameritrade. Image source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Aggressive investments like high-yield bonds aren’t for everyone. But the current low interest rate environment does make their yields look lofty.
“Chasing yield is never a good idea, and it comes with extra added risk,” Guarracino warned. “Municipals as a whole have a much lower default rate than corporate bonds. Look at the rating and read the rating agency reports, and if you do go down the credit scale to obtain yield, understand the risk.”
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