Higher Rates Usually Equal Higher Risk


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Higher Rates Usually Equal Higher Risk

  1. 1. RES-3405-U JUL 2009 Page 1 of 3 U K S t r a t e g y r e p o r t HigHer rateS USUally eqUal HigHer riSK Whilst performing well at times in the past, high-yield bonds (also known as ‘junk’ bonds) and high-yield bond funds have also performed poorly at times. Although high-yield bonds offer higher rates of return, the trade-off is that they also typically carry higher risk. Investors Beware: High-yield Bonds Are High-yield Bond Funds Right for You? Can Have Higher Risk Because of the above-mentioned risks, we don’t believe You should consider high-yield bonds and bond funds as individual high-yield bonds are appropriate for individual aggressive-income investments (because of lower credit investors. However, if you find it’s appropriate to own this quality and higher default risk) when you compare them type of niche investment, despite the risks, consider to investment-grade bonds. As the chart below shows, high-yield bond funds. The professional management and investment-grade bonds are rated Baa and above by diversification benefits these funds provide can help Moody’s or BBB and above by Standard & Poor’s (S&P), reduce some of the credit risks. But owning diversified which are independent organisations that rate the credit high-yield bond funds doesn’t reduce all risks. In fact, quality of bond issuers. high-yield bond funds typically exhibit a high degree of price and income fluctuation. As a result, they may not be S&p Moody’s appropriate if you tend to be a more conservative investor. AAA Aaa There is a false perception among some investors that AA Aa Investment Grade rising interest rates don’t negatively affect high-yield bond A A prices. In fact, rising interest rates generally do have a BBB Baa negative impact on high-yield bond prices. However, at BB Ba times increases in interest rates are accompanied B B by declining default rates. When this happens, the CCC Non-investment Grade Caa improvement in default rates typically offsets at least CC (High-yield or ‘Junk’ Bonds) Ca some of the impact of rising interest rates. C C Investors usually look for the possibility of greater rates D of return when they assume greater risk. The long-term returns of high-yield bonds, however, have been somewhat mixed despite their higher degree of risk. As the chart Historically, high-yield bond prices have been volatile, and below illustrates, investment-grade bonds have actually their income less stable, than those of investment-grade performed better than high-yield bonds during the past bonds. That’s because high-yield bonds default more 20 years. often than investment-grade bonds. In addition, high-yield bonds don’t provide the diversification1 benefits that investment-grade quality bonds can because their returns Historical annualised returns tend to be more closely correlated with share prices. Period High Yield Investment Grade As a result, we recommend you don’t consider high-yield 5 years - 3.9% 2.1% bonds or high-yield bond funds as a replacement for 10 years 2.2% 4.6% investment-grade quality bonds in your portfolio. 15 years 4.3% 5.6% 20 years 6.3% 7.2% Source: Barclay’s Capital High-Yield Index vs. Barclay’s Capital Corporate Bond Index; data as of 31/12/08. Past performance does not guarantee future results. Performance does not include payment of any expenses, fees or sales charges, which would lower the performance results.
  2. 2. RES-3405-U JUL 2009 Page 2 of 3 What’s the Outlook? Our recommendation for aggressive-income investments, The primary drivers of the poor high-yield bond including high-yield bonds, in your portfolio is a range of performance in recent years include: 0% to 5% of investable assets. ❚❚ A sluggish economy More Volatility on the Horizon ❚❚ An increase in defaults from record low levels In past years, investors put more money into high-yield ❚❚ Increased investor demand for greater safety bond funds. However, lately this trend has reversed and more money has flowed out of these funds. When there Typically we measure the value of low-quality high-yield are more sellers than buyers, the demand for individual bonds and bond funds by comparing their rates with bonds by bond fund managers drops. If this reduced quality US Treasury bond rates.2 The smaller the difference, demand persists, it will likely contribute to continued or spread, between the two rates, the less you’re being market volatility. compensated for the increased risk that high-yield bonds could default — or stop making timely payments of Average Cumulative Corporate Bond Default Rates principal and interest. The chart below shows how the current spread has widened significantly in recent years 52.9% 1981–2008 and is well above its historical average spread of about 5.7%. 33.1% High-yield Bonds: Spread to US Treasury 19.3% 7.7% 2000 0.7% 1.2% 2.9% 1800 1600 AAA AA A BBB BB B CCC 1400 Spread 1200 Source: Standard & Poor’s 1000 800 Liquidity in the high-yield bond market also has diminished 600 400 recently. As a result, it’s sometimes more difficult to buy 200 0 and sell high-yield bonds quickly, particularly when a bond is in distress. This also has added to the volatility of JAN 95 OCT 95 JUL 96 APR 97 JAN 98 OCT 98 JUL 99 APR 00 JAN 01 OCT 01 JUL 02 APR 03 JAN 04 OCT 04 JUL 05 APR 06 JAN 07 OCT 07 JUL 08 APR 09 ■ = Historical average spread ■ = Current spread high-yield bond prices. Basis points spread to US Treasury bonds. 100 basis points = 1%. Source: Barclay’s There are three primary factors driving reduced liquidity: Capital 01/05/09. Past performance does not ensure future results. Diversification does not guarantee a profit or protect against loss. 1. The credit crunch and the weak economy 2. Fewer market makers due to mergers, acquisitions and However, we do not believe that the wide spread indicates bankruptcies a buying opportunity. Although annual default rates for 3. Limited exposure by remaining market makers to high-yield bonds were only 4.1% at the end of 2008, high-yield bonds due to prior losses Moody’s expects them to quadruple by the end of 2009. Higher default rates tend to drive high-yield bond prices lower. Whilst it may be appropriate for some investors to own aggressive high-yield investments in the proper amounts, we don’t believe there is a compelling reason to do so at this time. Historical Annual Default Rates for High-yield Bonds 18% 16% 14% Default Rate 12% 10% 8% 6% 4% 2% 0% 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 (est.) 2009 Source: Moody’s
  3. 3. RES-3405-U JUL 2009 Page 3 of 3 The Bottom Line Sometimes it can be difficult to determine whether you own Keep in mind the following guidelines if you’re considering an aggressive-income investment just by its name, particularly high-yield bond funds: with a bond fund. On your Edward Jones statement, ❚❚ Be aware that the trade-off for higher rates of return aggressive-income investments are labeled as such. is greater risk of default and price volatility. Talk with your Edward Jones financial adviser to help ❚❚ Maintain reasonable expectations. determine whether these aggressive-income investments ❚❚ Consider reducing your exposure if your long-term make sense for your situation. objectives have changed or your portfolio is too heavily concentrated in high-yield bonds or high-yield bond funds. 1 Diversification does not guarantee a profit or protect against loss. We recommend that your overall portfolio does not 2 US Treasury bonds are used as the benchmark because the US has a more active and contain more than 5% aggressive-income investments. developed high-yield bond market. ❚❚ Keep in mind that a weak economy and rising default rates are likely to have a negative impact on high-yield bonds in the short term. Before investing in bonds, you should understand the risks involved, including interest rate risk, credit risk and market risk. The value of bonds fluctuates, and you may lose some or all of your principal. Corporate and government bonds are traded on an agency basis. Orders for corporate and government bonds received outside of trading hours, or before 11:00 a.m., will be transmitted for execution from 11:00 a.m. Please refer to our Terms and Conditions of Business for additional information regarding our Best Execution Policy. Full details about corporate and government bonds are available from your Edward Jones financial adviser. Mutual funds (the bond funds, high-yield bond funds and junk bond funds mentioned in this article) are subject to market risks, including potential loss of principal invested. Mutual funds are offered and sold by prospectus. Before investing, request a prospectus from your Edward Jones financial adviser, and read it carefully. The prospectus contains more complete information, including a discussion of risk considerations, charges and ongoing expenses as well as other important information you should carefully consider before investing or sending money. Edward Jones Limited is authorised and regulated by the Financial Services Authority and is a member of the London Stock Exchange. Registered in England and Wales No. 3403976. 11 Westferry Circus, Canary Wharf, London, E14 4HH. © 2009. Mario D. De rose, CFa Fixed Income Strategist www.edwardjones.com