Canadian investors are traditionally conservative. For bonds, that means they have a bias toward investment-grade issues and away from higher yields.
By doing so, they could be effortlessly leaving a lot of income on the table.
Investment-grade bonds are those with at least a triple-B-minus rating from Standard & Poor’s (or the equivalent from another bond rating service.) There are nine ratings higher than that, ranging up to triple-A. Non-investment grade bonds begin with a double-B-plus rating, and there are seven ratings below that.
Yet, non-investment grade bonds often just get lumped in together in an investor’s mind. Many feel that issues rated lower than investment grade should be eschewed as those bonds could be headed toward default or some other and costly credit event.
When I began managing bond portfolios, high-yield debt was often dismissed with the pejorative “junk bond” label. My initial role when starting my career as an analyst at a ratings agency was to monitor the lower-rated bond holdings in the investment-grade category to ensure they didn’t get downgraded to non-investment grade.
However, outright rejecting high-yield debt is a mistake. Most issuers of high-yield debt do not immediately default, if ever. In fact, many go on profitably for decades, never missing a coupon payment. The fears of many investors do not line up with the historical empirical data.
Ironically, this irrational fear adds to the attractiveness of the asset class. In aggregate, and over significant time periods, high-yield corporate debt trades at more attractive yields than their credit risk would justify. This has a lot to do with the fact that so much of the investment public fears them. And, more so in the present than past, public pension funds were prevented from holding them. Pension funds were required to sell corporate holdings that dropped to non-investment grade. These situations provided great opportunities for clever investors to buy artificially cheap bonds as a result of forced sales.
I have always found it counterintuitive that many institutional and retail investors will avoid buying the bonds of a company whose debt is below investment grade but happily buy the same company’s equities.
This logic is based on one or both of two assumptions.
One is that they fear bankruptcy of the firm and the loss in part or in whole of their bond investment. Yet, most high-yield corporate debt issues will be paid in full at maturity, never missing a coupon payment. This is especially true of issues of shorter durations. Obviously, the longer the term to maturity of a corporate issue, the higher the probability of a credit event. As an example, the probability of Disney filing for Chapter 11 in the next two years is extraordinarily small. Whatever default risk is in the next 30 years is difficult to determine, but it is higher than the next 24 months. A good question therefore to ask, is “If you won’t lend company X money for a year or two because it might default, why would you own stock in the company?”
The second assumption is based on a misperception of risk and return. Investors often argue that stocks have unlimited upside while corporate bonds mature at par. This logic forgets the fact that unless there is a disastrous credit event, bond investors will get all their money back in most cases and will be ahead of equity investors if there is a default. Bondholders usually get paid first out of asset sales. More importantly, if a company collapses, so does its stock price.
Investors should always consider the risks and rewards when choosing between stocks and bonds. Let’s take the example of a corporate bond yielding 3.5 percentage points above a Government of Canada bond that is going for 3 per cent, making for a total yield of 6.5 per cent. An investor needs to ask whether the stock will return at least that amount over the next year. In 2022, most companies did not. And what if the economy and company does well in the year ahead? That would mean a lower spread to government bonds. The price of the bond, which moves inversely to yield, would go up. Good news for the credit investor.
Right now, high-yield debt in Canada overall yields a little less than 3.5 percentage points above government of Canada bonds. This is about 70 basis points – a basis point is 1/100th of a percentage point – narrower than US spreads. (The conventional explanation is that the Bank of Canada is ahead of the Fed in its hiking cycle. It may also be that investors believe future Canadian inflation is likely to be less than that of the US, or that US federal debt levels are relatively higher than Canada’s.)
So Canadian bond investors are getting less yield on a bond with the same term. This is why I think investors in this country should favor internationally diversified exchange-traded funds. One to consider is the iShares US High Yield Bond Index ETF (XHY-T), which is hedged back into Canadian dollars, eliminating currency risk. It has a competitive management expense ratio of 0.67 per cent. The TD Active US High Yield Bond ETF (TUHY-T) with an MER of 0.62 per cent also provides exposure to the asset class. There are many other choices.
All this doesn’t mean an investor should suddenly load up on high-yield debt right now. I’m concerned that the amount high-yield bonds are yielding relative to government bonds is too small given where we are in the economic cycle.
These spreads have narrowed in the US recently, meaning investors are getting compensated less for the risks they are taking. Either high-yield debt managers are forecasting a far better economy than other market participants, or there is a supply/demand issue affecting bonds.
Historically, spreads correlate with stock market volatility and widen dramatically during periods of economic anxiety. The CBOE Volatility Index (VIX) is currently near its lowest level of the past year.
Consequently, although high-yield debt is an attractive asset over the long run, now might not be a good time to buy or be overweighted. When and if we see the VIX spike, and spreads widen significantly, investors will be provided with an opportunity to put their fears aside and jump into a market that can provide handsome returns.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.