Download High Yield Bond Prices – Are They Exhausted?

Information Note
Gillette Wealth Management Group
High Yield Bond Prices – Are They Exhausted?
In an effort to achieve yield on bonds in an environment where interest rates are so very low
some investors are willing to compromise on the credit quality. Movement away from “AAA”
credit quality Government of Canada bond issuer towards a Government of Ontario “A” credit
quality for the “buy & hold” investor is not what we are referring to. The “high yield” universe
of bonds and products and trading has existed for some time, and is where terminology the likes
of “junk bonds” is commonly used. While the principles of buy & hold to maturity on bonds has
not changed for investors at any level, products accessible to retail investors controlled by the
institutional/professional representatives has run aground of late in-line with prices topping out
as shown in the chart below (see exhibit 5). The price trend in the last 5 to 10 years and
throughout the last few decades provides a wonderful view of how high yield bond prices have
performed. Prices are now at an all time high. Despite current low interest rates and the desire for
all investors to obtain high levels of fixed income without risk, it seems obvious that from a
historical perspective, that the lower quality/higher yield counterparts of the marketplace may
have little to offer investors in the years ahead. No matter the risk/return metric, “high yield”
investment products continue to attract cash flows, as credit quality considered “investment
Grade” or better draws less (see chart in exhibit 1). This data is interesting as it displays either
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Gillette Wealth Management Group
how desperate the investor is to get yield at the expense of quality, or perhaps that they do not
understand the relationship between the credit quality of issuers of bonds and the rate of interest
coupon. There are now many products available in the marketplace that use the “high yield”
terminology. The complexity and credit quality of the securities inside the products that come
with the attractive “high yield” branding can be misunderstood. While it is interesting to note the
broad change in credit quality sought by the investor, it is also interesting that the current “high
yield” investor accepts one of the lowest trade-offs in yield to risk. The examination of Exhibit 2
clearly shows how low the coupon rate is on the lower credit quality bond issues. Seen another
way lower quality bonds bought by the investor today pay them a lower yield than the same
quality bond has paid investors at any point going back almost 20 years. This chart also shows
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Gillette Wealth Management Group
how the “high yield” bond investor suffered serious decline in price (while yields spiked moving
sharply upwards in the opposite direction to prices) during the 2002 through 2008 or so period.
Recall that this period followed a sharp correction in equity markets following the “dot-com
boom & bust” of 2001. Steep stock market declines are often characterized by the retail investor
doing exactly what they should not do, load up on bonds. For the investor who remembers this
period, the chart in Exhibit 2 clearly shows that bond prices just recently returned to the price
levels of the 2002 through 2006 period. Any maturity or sale of the bond or bond product prior to
price recovery would have resulted in a capital loss. Any capital loss can easily wipe out the
extra interest yield earned through additional risk taking on the purchase of a lower credit quality
(i.e. “high yield”) bond. No matter how you look at the data, the risk of considering this
investment class at this time is higher than ever. Some could argue that price changes were not
the same in different areas of the low credit quality universe. Exhibit 4 clearly demonstrates that
the relationship is similar at all levels.
While the Gillette Wealth Management Group does not promote low credit quality fixed income
products, we have however noticed an appetite in the community. This data is important
information for both the investor considering “high yield” investing, and as a reminder to those
investors that avoid this particular risk taking in favour of strong credit quality bond issuers.
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