Last updated: 09:45 / Thursday, 27 August 2015
Analysis by Eaton Vance

Why High-Yield Bonds Are Compelling Now?

Why High-Yield Bonds Are Compelling Now?

High-yield bonds occupy a special niche within the fixed-income market. These bonds, which are issued by companies with below-investment-grade credit ratings, offer higher yields to compensate investors for accepting exposure to additional credit risk. Generally, the lower the bond rating, the higher the yield.

Traditionally, companies with poorer credit ratings have issued high-yield debt to finance mergers or buyouts to help meet expanding capital needs. However, in recent years, more high-yield bonds have been issued to refinance existing debt. Companies have taken advantage of low interest rates and investors’ increased appetite for higher-yielding income investments to lock in relatively cheap financing. Situations where companies refinance their debt at more favorable rates generally put them in better financial health. Consequently, they tend to involve significantly less risk of default.

High-yield bonds are atractive to a wide range of investors because of their unique set of attributes. They appeal to investors who seek equity-like returns at much lower volatility levels than equities and to those who seek income with relatively low interest-rate sensitivity.

For the past five years, the high-yield market generally has been improving. These are, for Eaton Vance, four reasons to invest now in high-yield:

1. Low default rates.

The default rate has been below 2% in each calendar year since 2010, and as low as 0.6% in 2013 and early 2014, before rising to 2.0% with the default of TXU, a large high-yield bond issuer. This compares very favorably to the

10.3% default rate that was briefly reached in 2009, in the early aftermath of the credit crisis. It also stands well relative to the asset class’s long-term average default rate of 3.9%.

2. Healthy balance sheets.

Corporate balance sheets of below-investment-grade firms are generally in good shape and likely to improve as the economy gradually continues to recover.

3. Higher-quality issues.

The quality of new high-yield bond issues has been relatively good for several years, with 56% of issues currently being used to refinance debt, which is generally a positive scenario, bolstering company financial health. Conversely, fewer high-yield bonds being issued are lower-rated or being used to finance acquisitions and buyouts.

4. Low leverage

Another positive trend is that the leverage ratio of debt to EBITDA now stands at around 4, which is roughly where it’s been for about four years after peaking at about 5.2 in mid-2009. This is a reflection of the diligent work by many corporations to strengthen their balance sheets as well as more prudent stances taken by financial institutions and by investors in general.

With all that said, it is important to be mindful of market changes and the risks of deteriorating credit standards as the credit cycle changes at some point. For instance, a rise in the issuance of CCC-rated lower-quality debt could be a warning that the credit cycle is nearing an end. These riskier bonds tend to accompany an upswing in aggressive leveraged buyouts and indicate an increase in the high-yield market’s overall risk exposure.

Eaton Vance is mindful of quality within the high-yield market and the importance of being compensated appropriately or sufficiently for higher levels of risk. If yields are only rising incrementally for much higher levels of risk, it may be wise to pass rather than take on higher or excess levels of risk. "In brief: Ask if you are being paid appropriately or if risk is being appropriately priced", said the firm.