High-yield bonds have become a hot story in the last few months, with many market participants wondering what the effect might mean on the broader market. DoubleLine Capital LP’s Jeffrey Gundlach and others have cited declines in high-yield bonds as a sign that U.S. stocks are poised to fall. The conclusion hinges on the relationship between the two securities.
Here is the correlation between the overall stock market and high-yield bonds. Even though they are still technically “bonds,” junk bonds reflect a higher-risk portion of the spectrum, and hence trade more similarly to stocks. Looking back almost 30 years, US high-yield bonds have exhibited a correlation of only 0.22 to a broad universe of investment-grade bonds, and a correlation of 0.14 to US Treasury bonds, the traditional bellwethers of the US bond market. But, high yield’s long-term correlation to US stocks has been 0.61 and to global stocks has been 0.60. These correlations show clearly that high-yield bonds have tracked stocks more closely than they’ve tracked bonds.
Why is this? High-yield bonds, like equities, are strongly linked to the business results and fundamentals of the companies they represent and generally insensitive to interest rates—the dominant risk factor for many investment- grade bonds. The question then is “Are high yield bonds a tactical way to derisk one’s equity portfolio?”
Future Wealth’s View
While it is true that high-yield bonds are traditionally riskier than some other bonds and they have historically outperformed Treasurys, while at the same time exhibiting less volatility than stocks, high yield investments could suffer similar declines to an equity portfolio. Most money managers would say that if an investor cannot hold on through a 30 percent price decline in their high-yield investment, then they should not be in the high yield space. But then, most conservative investors would be unwilling to take a 10 percent price decline in an equity portfolio and even less in a bond portfolio.
And therein lies the conundrum. Even though they are bonds, and yet, they act more like stocks and since the low-rated bondholders are second to last, next to stockholders to get paid off in light of financial distress, we, at Future Wealth, see little reason to put our clients into these high-yield bonds.
But, whether the recent decline in high yield bonds is a harbinger of a similar decline in stocks is one that we struggle with. Only time will tell. But, in the meantime, there is a reason for these bonds to be fondly called “junk bonds”.