High-yield corporate bonds have built a big edge in income yield over Treasury bonds over the past few months. Some people prefer the perceived safety of Treasury bonds and accept the lower income stream (even if it means a negative return after accounting for inflation). The fear is that high-yield corporate bonds have a higher default rate. But according to Fidelity Investments, in order for high-yield bonds not to perform better than Treasury bonds over the intermediate term, default rates would have to rise from currently between 1 and 2% all the way to 10%.
According to a recent market analysis from Charles Schwab, Moody’s projects a peak high-yield default rate of 9.4% in the case of severe recession. Going back to November 2009, corporate bond defaults peaked at 14.5%. The Moody’s stress test uses an unemployment spike to over 13% and a dramatic rise in the cost of high-yield debt (to the levels seen in 2008–2009).
Schwab’s Rob Williams (Director of Income Planning) and Kathy Jones (Fixed Income Strategist) wrote: “We’re nowhere near either of these possibilities at the moment, in our view. Unless we see a severe economic downturn, yields north of 9% for high-yield bonds—where they are currently on a broad index—may be enough to compensate for volatility and defaults for more risk-tolerant investors. Bottom line: Adding yield when spreads compared to Treasuries widen, in our view, can make sense for investors interested in corporate bonds now that yields have risen.”
High-yield bonds collectively have average yields over 8%.
Certainly, if recession returned, conditions would change but at this point, concern of recession has eased. We find that using multi-sector bond mutual funds where the managers have flexibility to shift to the most relatively attractive segment of the global bond markets, is a good way to gain exposure to high-yield bonds.
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA