Fixed Income 101: Understanding U.S. Corporate High-Yield Bonds

What is a High-Yield Bond ETF?

A high-yield bond ETF is a type of investment vehicle that primarily holds a collection of high-yield bonds as its underlying assets.

These bonds, commonly known as “junk bonds,” are characterized by their ratings below investment grade, typically BB or lower, as assessed by major rating agencies.

The classification of these bonds as below investment grade reflects the heightened risk associated with their issuers, who are considered more likely to default on their debt obligations.

This default risk could manifest in the form of missed interest (coupon) payments or failure to return the principal amount.

Despite the increased risk of default, high-yield bonds offer a significant advantage: they typically provide much higher yields compared to investment-grade corporate bonds. This higher yield compensates investors for the additional risk they undertake.

Moreover, as a bond investor, one still enjoys the hierarchical benefit in the capital structure, meaning in the event of a company’s liquidation, bondholders are prioritized over equity and preferred stockholders for any payouts.

High-yield bond ETFs offer several advantages over purchasing individual high-yield bonds. One of the primary benefits is diversification. By investing in a high-yield bond ETF, you gain exposure to a broad range of bonds, thereby spreading out and potentially reducing the risk associated with any single issuer.

Another advantage is the frequency of income distribution. While individual high-yield bond issues typically pay interest semi-annually, high-yield bond ETFs often provide monthly distributions, offering a more regular income stream. This feature can be particularly attractive for investors seeking consistent cash flows from their investments.

Advantages of High-Yield Bonds

Historically, high-yield bonds as an asset class have provided competitive total returns, falling somewhere between aggregate bonds and domestic total equity market returns.

As seen above, high-yield bonds returned an annualized 6.48% from 1987 to the present, compared to 10.08% for the U.S. stock market and 4.91% for aggregate bonds. Risk-adjusted returns were competitive too, with a Sharpe ratio of 0.50.

The current yields investors can expect with a high-yield bond ETF are nothing to sneeze at. Examples like the WisdomTree US High Yield Corporate Bond Fund (WFHY) and the SPDR Bloomberg High Yield Bond ETF (JNK) and are paying a yield to maturity of around 8.5% right now despite having a fairly low duration (a measure of interest rate risk).

Disadvantages of High-Yield bonds

These stellar yields come at a cost though. The much higher credit risk of these bonds has historically resulted in steep drawdowns during various economic crises. When turmoil strikes, worries of their issuers defaulting come to the surface, and these bonds can sell-off.

As seen above, the drawdowns experienced by high-yield bonds fall somewhere between aggregate U.S. bonds and equities. Investors should not expect that these bonds are a free lunch – for example, they fell by 28.46% during the depth of the 2008 financial crisis.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.