Download The ups and downs of high- yield bonds

Market & Investment Insights
The ups and downs of highyield bonds
Kevin Lorenz and Jean Lin, portfolio managers for TIAA-CREF
High-Yield Fund
Article Highlights:
• High-yield bonds offer investors higher interest payments than investmentgrade bonds in exchange for taking on greater risks of default and price
volatility.
• The recent drop in oil prices offers a good example of how market volatility
can affect high-yield bonds.
• Lower oil prices raised the possibility that some companies in the energy
sector may default on their debt, causing high-yield bond prices to fall.
• However, many of those bond prices have since rebounded, as the drop in
price raised the bonds’ yields, increased demand from investors.
• While the oil price drop may lead to more defaults, the high-yield market still
offer attractive opportunities, as a strengthening U.S. economy will probably
keep overall default rates low.
• If interest rates rise as the economy gains strength, high-yield bonds are
likely to outperform Treasuries and other high-quality bonds.
May 21, 2015
For more than a decade, the income offered by Treasury and high-quality
corporate bonds – bonds with an “investment-grade” credit rating – has fallen
steadily and is now close to a record low. In order to cope with this decline, some
investors have shifted assets into high-yield bonds as part of a long-term strategy
to generate income. The issuers of these bonds have lower credit ratings, and a
higher risk of defaulting on their debt, than investment-grade companies, so they
pay higher rates on the money they borrow.
The risk/return profile of high-yield bonds makes them more sensitive to sudden
market shifts relative to other fixed-income securities, putting them in something
of a middle ground between high-quality bonds and equities. For long-term
investors who can look past periods of market volatility, high-yield bonds offer a
good way to diversify a portfolio’s volatility and can enhance risk-adjusted return.
The ups and downs of high-yield bonds
Oil’s price plunge
One such market shift happened in December 2014, when oil prices plunged to less
than $60 per barrel from close to $100 earlier in the year. As oil prices fell, the BofA
Merrill Lynch US Cash Pay High Yield Index (of which energy companies comprise
about 18 percent), slumped about 3.5 percent in the space of two weeks to its lowest
in a year, shown here in Exhibit 1.
The oil price slide raised concerns first about the financial health of domestic energy
producers, many of which issued high-yield bonds to fund an ambitious expansion in
shale deposits in North Dakota, Texas and Pennsylvania. The price decline spread
across the high-yield market to other energy companies, and eventually even to
those with little or no direct exposure to oil prices.
Since then, however, high-yield bond prices have rebounded, even while oil prices
have remained low. Oil prices have recovered somewhat over the last few months.
In December, as bond prices fell, yields rose, because yield – or the amount of
income per dollar of market value – rises as the price of a bond falls. A more dovish
tone from the Federal Reserve on its timing for interest rate hikes this year coupled
with higher yields on high-yield bonds attracted more investors and boosted prices
back to where they were before, even though oil prices have stayed low.
Taking a long-term view when volatility strikes
For those investors who take a long-term perspective—as most should—these
events should be viewed as fairly normal in the high-yield market. Sometimes
events such as falling oil prices cause volatility to rise, but that does not always
result in significant negative shifts in overall market fundamentals. That’s why it’s
important to seek out an approach to high-yield investing that focuses on quality
opportunities in the sector, since there are a great variety of companies within the
high-yield universe, and quality varies among them. By analyzing each company’s
individual operations and focusing on the stronger companies, investment managers
can identify issuers that are able to service their debt in challenging environments
and thus are more likely to withstand market volatility.
The ups and downs of high-yield bonds
Although the drop in oil prices has introduced added uncertainty into the market,
there are still plenty of attractive companies within high yield, and its fundamentals
as an asset class should remain strong even if oil prices stay low or fall further.
Default rates are historically low—about 2 percent in 2014, compared to a long-term
average of about 4.5 percent. Although default rates might increase slightly in
response to the decline in oil prices, we believe the strengthening U.S. economy will
likely keep default rates below historical averages. Consequently, we believe
current yields are attractive given the fundamental risks.
A stronger U.S. economy could also lead to higher interest rates, which tend to push
bond prices lower. By contrast, high-yield bonds often benefit more from the stronger
economy than they are hurt by higher rates as they are more sensitive to default
rates than interest rates. That means high-yield could deliver better performance
than Treasuries and other higher-quality bonds if the economy keeps growing
stronger and interest rates start going up. On the other hand, if the U.S. were to slip
into recession, high-yield would likely underperform Treasuries and other higherquality bonds but could potentially outperform the stock market.
Avoid temptation to react to headlines
High-yield investors should avoid the temptation to get caught up in short-term price
and spread volatility of the asset class and focus instead on long-term fundamentals
such as economic growth and default risks. A strategic allocation to high yield
continues to offer compelling benefits for diversified, long-term investors. If you have
questions about how high-yield bonds can play a role in a diversified portfolio, talk to
your TIAA-CREF advisor for more information.
This material is prepared by and represents the views of Jean Lin and Kevin Lorenz, and does not necessarily
represent the views of TIAA-CREF, its affiliates, or other TIAA-CREF Asset Management staff. These views are
presented for informational purposes only and may change in response to changing economic and market conditions.
This material should not be regarded as financial advice, or as a recommendation or an offer to buy or sell any
product or service to which this information may relate. Certain products and services may not be available to all
entities or persons. Past performance is not indicative of future results. Economic and market forecasts are subject to
uncertainty and may change based on varying market conditions, political and economic developments.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF
group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance
and Annuity Association® (TIAA®). Teachers Advisors, Inc. is a registered investment advisor and wholly owned subsidiary of Teachers Insurance
and Annuity Association (TIAA). Past performance is no guarantee of future results.
Diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss.
Please note investments in high-yield bond securities are subject to interest rate and inflation risks, and significantly higher credit risk.
You should consider the investment objectives, risks, charges and expenses carefully before investing. Please call 877-518-9161or log on to
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