Integrating High Yield Bonds into a Fixed Income Portfolio

Introduction into a Diversified Fixed Income Portfolio

Hemispheres Investment Management offers a Core-Plus Bond Strategy. The “Core” portion of the portfolio consists of a highly diversified portfolio such as found in the Bloomberg Aggregate Bond Index. The “Plus” component of the portfolio represents strategic allocations that Hemispheres views as offering compelling potential investment returns. When attractive valuations are present, the portfolio may include investment-grade, below investment-grade and global bonds, including emerging market securities. The portfolio may also contain convertible bonds and preferred securities when valuations are compelling.

The Bloomberg Aggregate Index skews toward higher quality bonds, providing low investment risk and offering diversification benefits compared to equities. In fact, the correlation between investment grade bonds to the S&P 500 is only 0.05.  A correlation of less than 0.7 indicates that adding bonds to an equity portfolio lowers risk. This feature is particularly beneficial in bear market situations or as a means of matching a portfolio with a client’s risk tolerance. Unfortunately, prior to the past 18 months and over the past decade, the exceptionally low interest rates did not provide strong investment returns. By strategically adding high yield bonds with attractive valuations, Hemispheres optimizes client returns relative to the benchmark all while maintaining high overall investment grade portfolio credit ratings and improving diversification.

Bloomberg Aggregate Index

Hemispheres Investment Management utilizes the Bloomberg Aggregate Index as its fixed income benchmark.

As of July 2024, the index includes 2,324 bonds with an average maturity of 8.41 years. The benchmark heavily weights its holdings toward the U.S., which accounts for 93.05% of the total. All other country weightings account for less than 7%, of which 0.93% are from emerging markets. Treasuries, Mortgaged Backed Securities and Agency securities comprise 71.88% of total holdings while corporates make up less than one quarter of the index.

What is a High-Yield Bond?

A high-yield corporate bond is a classification of debt security that carries a higher risk of default than higher rated bonds. Credit agencies like Moody’s, Standard & Poor’s, and Fitch rate companies that issue publicly traded debt. These agencies assess the probability of default risk. Companies perceived to have a higher risk of default receive ratings below investment grade, commonly known as speculative grade or junk bonds. To attract investors, these bonds offer significantly higher than market interest rates, compensating for the increased risk.

Companies that issue high-yield bonds are typically highly leveraged, face financial difficulties, have small capitalization, or lack an established track record.

Key Risks of High-Yield Bonds

High-yield bonds can appeal to investors with a higher risk tolerance. This is particularly true, when the high yield bonds are part of a diversified portfolio where the aggregate credit rating remains high. Even so, understanding the associated risks is crucial before diving into these investments.

Default Risk

Also known as credit risk, is the possibility that a company may fail to make timely interest or principal payments, leading to default. A payment default can result in costly debt restructurings or in a worst-case scenario, bankruptcy.

As of June 2024, S&P Global anticipates the North American speculative grade debt default rate to be approximately 4.5%[1]. We anticipate a decline in the default level as interest rates decrease in a “soft-landing” economic environment and as corporations refinance and extend debt maturities. At any time in the economic cycle, default rates may increase for companies in specific sectors. During 2024, default rates increased in health care and high-tech sectors. All other sectors saw lower rates of default than in 2023.

Interest Rate Risk

Bond prices and market interest rates move in opposite directions. This inverse relationship affects all bonds. The longer the bond’s maturity, the more susceptible it is to interest rate changes, amplifying the pricing risk.

We expect bonds to benefit from capital appreciation as interest rates decline.

Economic Risk

In an economic downturn, investors may prefer owning higher quality bonds with less default risk. When selling momentum grows, high-yield bonds prices might drop sharply.

Should the investor own speculative grade credit in this environment, however, an assessment of corporate staying power becomes critical. Credit analysis is key to achievement of a successful outcome.
In addition to the factors considered in typical fundamental analysis, we focus on the timing of debt maturities and access to capital through alternative financing, such as bank credit. If the corporate entity has staying power, meaning it can service debt and fully meet the terms of the Indenture (lending agreement), holding the bond to maturity and receiving repayment at par is a good strategy.

Liquidity Risk

Liquidity refers to the ease of selling an asset for cash. Bonds traded frequently and in high volumes generally have good liquidity. High-yield bonds trade less frequently and face higher liquidity risk than investment grade bonds. Therefore, you might not get a price that accurately reflects the value when selling.

Patience may be required in this situation, as periods of illiquidity are often temporary. Another way to mitigate this risk is to evaluate the market size of the speculative grade bond under consideration prior to investment. Buying a security from a larger market-sized company mitigates much of this risk.

Other Risks to Consider

Leverage in Fixed Income ETFs

Many of the Fixed Income ETFs utilize leverage which amplifies performance as well as all the aforementioned risks. In an adverse market, this could lead to significant losses. Hemispheres investment Management does not utilize leverage in its strategies.

Emerging Markets Economic and Political Risks

The economic cycles of emerging markets often differ from those of the developed world. This cyclical difference can provide opportunities for investors when economic conditions are less than robust in the U.S.

Not all countries have the same monetary and fiscal policies and those policies matter to foreign investors. All the countries HIM invests in have regulatory oversight of their listed companies. Many of these firms dually report in formats that conform with U.S. Generally Accepting Accounting Principles [GAAP] and international accounting standards.

Despite the favorability of regulatory oversight, it is important for investors looking for diversification and return opportunities available in emerging markets to seek expert advice.

Conclusion

Adding an allocation of select high yield bonds can enhance returns while maintaining a portfolio aggregate high investment grade rating. We should point out that with a 4.5% default rate in 2024, 95.5% of speculative grade debt performed as agreed. A skilled and experienced investment manager plays a crucial role in global fixed income investing, particularly regarding high-yield investments where analysis is central. An experienced advisor can assist you in navigating the geopolitical, regulatory, economic and market risks. Furthermore, adding global securities, including emerging market bonds, can provide diversification benefits to a fixed income portfolio.

Hemispheres Investment Management’s team of seasoned professionals have a 35-year track record of successful fixed income and equities investment strategies, including deep proficiency investing in US, international developed and emerging markets. Hemispheres can assist you in diversifying and enhancing your fixed income portfolio through the addition of high yield bonds.

Please contact Hemispheres Investment Management for a free consultation. We provide guidance and strategies to assist you in optimizing your investment portfolio and helping you achieve your investment goals. Book a meeting.

[1] 101600043.pdf (spglobal.com)