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The yield for HYG, a high-yield (i.e. junk) corporate bond ETF, is currently 5.72% versus 3.56% for LQD, an investment-grade corporate bond ETF. Of course, higher yield generally means higher risk. But don't these yields already take into account defaults? In other words, say the average yield of the bonds HYG holds is 8%, but 25% default (effectively giving a yield of 0%), for an overall yield of 6%. If that is indeed the case, what is the risk of investing in high-yield versus investment-grade bonds? Is the worry that in a recession, such a high number of companies will default that the overall yield of HYG will drop below that of LQD? I looked at the yields during the 2007–8 financial crisis and didn't see evidence for this. I also figured maybe the price of HYG was more prone to fluctuation than LQD, but that doesn't seem to be the case either.

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Yes, current yields and current annual default rates go hand in hand.

In other words, defaults today are compensated with rates today; however, there does appear to be good predictive power in spreads:

enter image description here

In terms of risk, high yield is like insurance: it's great when you receive the premiums/dividends, but when the chickens come home to roost, reality is unforgiving.

The losses during recessions are enormous and can quickly be seen upon inspection, but for more practical data, we'll examine the assets you've referenced:

Investment grade

enter image description here

High yield

enter image description here

During the Great Recession, the worst credit crisis since the Great Depression, high-grade corporates lost less than 50% during a short time while high yield corporates lost approximately two thirds for an extended period.

During a more typical recession, the Tech Crash, investment grade corporates lost relative little while junk again lost almost half.

For these levels of risk, it's best to take on perfectly diversified corporate equity; however, the periodic negative beta is useful.

As for spreads, the higher, the worse. If an asset is yielding more, indicated by a higher or rising spread, the price is dropping.

Always remember the universal shorthand, the perpetuity:

P = i / r

Price is inversely related to rates. If the rates on junk went negative, it would be an indication that either the ratings system is broken or dogs & cats are living together, mass hysteria.

  • On the time scale of those graphs, high-yield spreads never go negative. So my question remains, what is the downside to high-yield bonds? – Craig W Jun 30 '14 at 20:20
  • @CraigW Please note edit. If my explanation is still lacking, be sure to let me know. – user11865 Jul 2 '14 at 4:09
  • Doesn't high-yield spread mean the difference in interest rates between high-yield and investment-grade bonds? Of course negative high-yield rates would be insanity. As to your overall answer, I understand if rates increased, bond prices would go down. But if one was already holding bonds (or a bond fund) and had no intention on selling them, would this be a major concern? – Craig W Jul 3 '14 at 15:24
  • @CraigW Yes, but it's high yield - investment grade, so a negative figure for that would indicate some sort of fundamental problem. The value theory, that "it doesn't matter so long as you don't sell", presupposes otherwise perfect liquidity. Reality is not as accommodating unless if you live a Dave Ramsey/Warren Buffett lifestyle. If liquidation value weren't such a problem, it wouldn't wreck such havoc. There is also the theory of opportunity cost: it would be far better to sell at peaks and buy at valleys. Value theory is a good long run solution, but the short run does exist. – user11865 Jul 4 '14 at 3:37
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The main danger of a junk bond fund is that there will be a higher rate of bankruptcy/default than in an investment grade bond fund.

As a graduate student at Wharton, Michael Milliken the (future!) "junk bond king" wrote a thesis that two percentage points were enough compensation for the likely higher default rate of a junk bond fund over a corporate bond fund.

  • But as I asked in my question, isn't default risk already factored into the yield (i.e. 5.72% is the return even with defaults)? – Craig W Jun 27 '14 at 18:21
  • @CraigW: No. The fund pays what the bond yields allow and worries about defaults later. They don't "reserve" for anticipated defaults. – Tom Au Jun 27 '14 at 18:22
  • So then there must be a risk of so many defaults that the yield drops below that of an investment-grade corporate bond fund. Are there historical cases of this happening? – Craig W Jun 27 '14 at 18:29
  • @CraigW: "You pay your money you take your chances." The times this happened was in "stress" periods like 1990-91, 2000-01, and 2008-09. At other times, you're "fine." – Tom Au Jun 27 '14 at 18:33
  • I don't see evidence of this in 2008–9 though. Taking a look at the dividends from September 2008 – September 2009, for example, with HYG I get a total dividend of $4.84, divided by an average share price of ~$80, for a yield of ~6%. For LQD it is $3.24, ~$100, and ~3%. – Craig W Jun 27 '14 at 18:59

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