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23 September 2015

US high-yield bonds 

Often referred to as “speculative”, "junk" or "high-yield”, this type of bond offers high returns in exchange for a higher level of risk on issuers than with other types of bonds.

This additional risk can be explained by various factors: a weak or weakened financial situation, inadequate balance sheet size, a sector in difficulties or an adverse economic context. In any of these cases, issuers' ability to meet repayment of their debt seems more limited, and they find their issues being assigned lower ratings than other corporate bonds.

The high-yield market is a very American one. With a volume of $1.4 trillion and more than 2,300 issues, it represents 30% of the total US dollar-denominated corporate bond market and more than 70% of the global high-yield market.

Highly diversified, this asset class covers a large number of sectors and has particularly significant exposure to the energy industry. That is why the performance of the high-yield market has recently been significantly impacted by the fall in commodity prices - particularly that of oil.

While 2014 ended on a somewhat reticent note as regards this asset class (the BofA Merrill Lynch US High Yield Index advanced by 2.5% while 1-10 year Treasuries posted a rise of 2.9% for the same period), the perception has changed in the past few months.

Why might the situation improve in the future? From a fundamental point of view, the US economy and job market continue to improve. This might lead the Federal Reserve to raise its key lending rate before year-end, if inflation forecasts improve.  

A rate hike would have an adverse impact on fixed-rate bonds, but the spread offered by high-yield bonds constitutes significant protection against this negative impact. Indeed, during three of the four periods of rate hike cycles seen since 1988, the high-yield market outperformed better quality bonds or Treasuries.

Moreover, thanks to low interest rates and increased investor appetite, many issuers have been able to improve their debt profile and refinance on a huge scale, with their indebtedness reaching levels not seen for 25 years.

The companies concerned also have large amounts of available cash. This improvement in corporate balance sheets, and repeated interventions by central banks, should keep default rates at relatively low levels, even though those in the energy sector are expected to increase.

Thus the universe of US dollar-denominated high-yield bonds seems increasingly attractive in managing a diversified portfolio. However, the underlying risk requires special attention, meticulous management and ongoing monitoring.

Disclaimer: The statements and views expressed in this document are those of the author as of the date of this article and are subject to change. This article is also of a general nature and does not constitute legal, accounting, tax or investment advice.