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Why I Abandoned High Yield Bonds

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Over the years, I have used high yield bonds as a hybrid asset class between stocks and higher grade bonds (like investment grade corporate bonds and US Treasuries).

Like stocks, high yield bonds benefit from improving business conditions, yet they rank higher on the capital structure because they are bonds. High yield bonds are issued by ‘below investment grade’ companies, and therefore pay higher coupons than investment grade corporate bonds because these companies come with a higher default risk. However, because of the higher coupons (and higher yield), high yield bonds have a lower duration (and are less interest rate sensitive) than lower-yielding bonds with a similar maturity.

Payments to bondholders typically take priority over stockholders – as a result, corporate bonds tend to be a less risky than the equity of the same company.

The Good Great

Believe it or not, high yield bonds have outperformed stocks from 1980-2019 with an average calendar year return of 15.10% vs 12.49%. Moreover, the worst calendar year performance (2008 for both) outperformed stocks by over 10 percentage points.

HY BondsInvestment-GradeStocks
Average Calendar Year Return15.10%7.81%12.49%
Worst Calendar Year Return-26.17%-2.92%-37.00%
Data source: High yield returns are represented by the Salomon Smith Barney High Yield Composite Index from 1980 through 2002, the Credit Suisse High Yield Index (DHY) from 2003 through 2013. From 2014 on, the S&P 500 Investment Grade Corporate Bond Index, and Federal Reserve Bank of St. Louis’ S&P 500 data were used.

Overall, the risk-return profile for high yield bonds has historically been quite favourable. After all, interest rates (as shown by the 10yr US Treasury yield in the chart below) have been in a bull market since around 1980. With this sort of tailwind, anything with a fixed coupon experienced long-term upward price pressure. This has been great for high yield bondholders.

The Bad

Looking at the chart below, one naturally has to wonder though if rates have bottomed for good. As I write this, the 10yr just moved above 1.3% for the first time since the pandemic began. With the firehose of fiscal and monetary stimulus expected to continue for the foreseeable future, it is likely yields continue to rise. I believe the Federal Reserve will allow the economy to run hot for a while before applying the brakes, so it is quite possible that both rates and inflation continue to creep higher.

While high yield bonds generally have a lower duration and benefit from an improving business environment, rising yields could put a damper on future returns expectations. At a minimum, I think it’s reasonable to argue that the capital gains are behind us, leaving only coupon clipping.

So why have I abandoned high yield bonds?

High yield bond yields have been pushed down to around 4%. As you can see in the chart below, this figure is historically low.

The following chart also shows yields on high yield bonds, but for a shorter time frame.

If high yield bonds are yielding a historically low 4% and rising interest rates act as a cap, at this point 4% is the best I can reasonably expect is for forward total returns on high yield bonds. I could be wrong, but given the information I have today I believe there are better alternatives.

You know what else yields about 4%? Royal Bank, Manulife Financial, TD Bank, Verizon and many other stocks out there. The kicker is that these companies will probably grow earnings and raise dividends over the years, flowing through a decent total return to shareholders. So at today’s cost, that 4% dividend yield could grow to a forward 5%, 7%, 10% yield on cost over several years. And as dividends grow, prices tend to follow. Try getting that kind of income stream and total returns profile from a bond.

So if the only remaining reason to hold onto high yield bonds is to collect the 4% yield, I’d rather move my money to dividend growth stocks. Consequently, I have sold all my high yield bond holdings and am redeploying into dividend growth stocks.