The compelling case for high yield bonds, and why they belong in HNW portfolios

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Since 1987, high yield bonds have delivered enhanced income vs. investment grade bonds, and “equity-like” total returns with approximately half the volatility of the S&P 500. Yet this asset class continues to be under-allocated to – or not present at all – among many high-net-worth individuals and family offices in Canada.

What is high yield?

High yield bonds are corporate debt securities with a credit rating that is below investment grade, as defined by the major credit rating agencies. For example, corporate bonds rated below BBB- by Standard & Poor’s or Fitch, or below Baa3 by Moody’s, would be considered high yield bonds.

After a wave of defaults in the late 1980s, high yield bonds were colloquially referred to as “junk bonds,” which tarnished the reputation of the high yield market as investors assumed that this was a risky asset class. As with many investment opportunities, somewhat greater volatility often goes hand in hand with significantly greater rewards, and high yield bonds have become a staple of well diversified investment portfolios.

Within the fixed income market, high yield bonds have historically shown a low correlation to other fixed income securities, thereby providing diversification benefits, but also enhanced returns versus traditional fixed income. The high yield market has evolved dramatically over the past four decades, and it now plays an important role among retail and institutional investors alike. Today, high yield makes up about 14% of the U.S. corporate bond market.

In the U.S., high yield bonds are an integral component in fixed income portfolios, but Canadians have been slower to seize the opportunity.

Enhanced income through higher yields

High yield bonds have a significant yield advantage compared to government bonds and investment-grade corporate bonds in order to entice investors to support these smaller companies. Historically, this yield advantage varied over time and fluctuated with the economic environment but generally ranged from 300 to 550 basis points of additional yield, or 3% to 5.5% of additional coupon. Today, the U.S. Government 10-year is at 3.8%, the U.S. 5-year at 4.0%, investment grade corporate bonds average yield to worst (YTW) around 5.5% and high yield bonds are offering a YTW of 8.5%.

Lower duration, less interest rate sensitivity

High yield bonds are typically issued with shorter maturities, mostly 10 years or less, and are often callable by the company, which results in a shorter maturity profile and much lower duration. This, in turn, makes high yield bonds much less sensitive to interest rate moves than investment grade bonds or government bonds.

High yield bonds tend to be more driven by underlying corporate earnings, individual issuer news and general economic outlook, and less so by interest rate moves. As a simple example, in a recovery phase of the economic cycle where rates are typically rising, high yield bonds are expected to outperform many other fixed income classes as high yield bonds are boosted by stronger earnings and improved operating environment – making them less risky and more desirable to investors.

Potential capital appreciation

There is no such thing as a typical high yield bond issuer. Companies as diverse as United Rentals, Ford Credit Canada, Videotron, Occidental Petroleum, and Superior Plus are high-yield bond issuers. Many companies like Tesla and Netflix grew through high yield financing and became investment grade over time.

Generally speaking, high yield issuers include fast growing companies that require capital to expand, and private equity-backed companies where debt is part of the acquisition funding.

As companies grow, and profits improve, this often leads to ratings upgrades, which result in lower yields and therefore higher bond prices. Most of these bonds are callable at prices above par, and companies with improving fundamentals usually call their bonds early to take advantage of a higher credit rating, as they can reissue debt at lower yields. Of course, if the individual issuer’s financial health deteriorates and/or rating agencies downgrade bonds, that would reduce the bond’s value and hurt total returns.

Individual security selection can play a significant role in high yield performance and is often important to consider when choosing between an active vs. passive approach to high yield investment management.

Diversification benefits in the Canadian market

The Canadian high-yield and investment-grade bond market tends to be more concentrated in certain industries. Canada has ample natural resources and benefits from a strong banking sector, which tends to concentrate bond offerings in the Canadian space. If you are looking for oil & gas exposure or financials (banking, brokerage, and insurance, for example) Canada has many strong offerings. However, other industries tend to be underrepresented with limited options. Pairing high yield bonds with an investment grade portfolio allows for significant diversification benefits across industries that Canadian investors otherwise do not have meaningful access to.

The goal in high yield fixed income investing is not to have the highest yielding strategy.

Liam Card, Lorne Steinberg Wealth Management

Most of the higher quality high yield bonds are going to be found south of the border, and while there are some to be found here in Canada (we own several), any well diversified strategy in this asset class is likely to be at least 60% U.S. / 40% Canada. Our firm chooses to hedge the U.S. dollar-denominated bonds to ensure that FX does not play a role in meaningfully affecting the performance one way or the other, and it is our strong recommendation that any Canadian domiciled family office, institution, or individual go this route to avoid currency risk.

Defaults and capital structure seniority

Simply put, defaults are a part of investing in this asset class. Across the high yield universe, the average default rate historically has been around 3.6%, and the return numbers in the chart below include the defaults. The default rate tends to rise when economic activity slows, and declines during periods of economic growth.

That said, the goal when running a high yield strategy should be to avoid defaults, and (like equities) bottom-up research should be done on every company in the portfolio, to help ensure a clear understanding of the business, the balance sheet, the offering, and protective covenants. Active portfolio management and ongoing monitoring should reduce the number of defaults over time, especially if there is a focus on the higher end of the high yield market, avoiding those bonds classified as “distressed debt.”

The goal in high yield fixed income investing is not to have the highest yielding strategy. Instead, it is to pick up yield in the higher quality sectors of the market while minimizing default risk. Unlike equities, high yield defaults rarely result in a complete loss of capital. Bonds rank above equities in the capital structure, and these bonds also include a number of protective covenants which further protects investors. Many high yield issuers have bonds with different levels of asset protection, and an important part of the research process is evaluating the risk/reward of these various bonds.

All of the above points to the fact that high yield investing is best done via an active approach vs. a passive one. For this asset class, research is the key.

“Equity-like” returns with half the volatility

Since 1987, high yield bonds have exhibited approximately half the volatility of the S&P 500. Investors in this asset class must accept some volatility in return for higher yields. From 1987 to the end of 2022, the average annual return of high yield bonds was 8.4%, in comparison to the average annual return of the S&P 500 at 11.9%. Over the same period, the average negative return year for high yield was -7.1%, and -15.1% for the S&P 500.

Said differently, high yield bonds offered “equity-like” returns with approximately half the volatility of the S&P 500, and one should note the behaviour of this asset class following a negative calendar year.

Since 1987, every single negative-return year in high yield has been followed by a positive-return year. In fact, the year following a negative year for high yield was, on average, a double-digit return.

While nothing is guaranteed, the asset class is positive on the year (as of May 31, 2023). This recovery phenomenon is largely due to the fact that high yield bonds are a much shorter duration/shorter-term-to-maturity asset class than investment grade bonds.

Here at Steinberg Wealth Management, our high yield fund has a duration of 3.2 years and an average maturity of 4 years. Therefore, with a shorter term to maturity, in any year following a negative year, many bonds will:

• Mature at par
• Move one year closer to maturity
• Be called by the issuer at a premium

Family office inclusion in Canada

The inclusion of high yield across institutional investors and family offices is far more prevalent in the U.S. than in Canada, which begs the question, “Why?” The asset class itself was born in the U.S. and is comprised of hundreds of issuers across many sectors. The Canadian high-yield market lacks adequate diversification, which poses a problem if one were attempting to create a purely Canadian high-yield strategy. That is why a currency-hedged, predominantly U.S. portfolio is the perfect solution.

Over the past four decades, the high yield market has evolved considerably since the “junk bond” days of the 1980s. With a deeper understanding of the asset class, how it behaves, the return profile, and diversification benefits, we expect this asset class to become a growing and important component of Canadian fixed income portfolios.

If there are any questions regarding high yield bonds, we invite you to reach out to our firm to continue the discussion.

Liam Card is a Senior Vice President and Portfolio Manager at Lorne Steinberg Wealth Management in Toronto. Lorne Steinberg Wealth Management is a private, investment counsel firm based in Toronto and Montreal, servicing clients across Canada and the United States. The firm focuses on Global Value Equities, Canadian Equities, High Yield bonds, and Investment Grade fixed income.

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