One of the questions that all debt investors ask is whether high-yield bonds face higher default rates and more volatility. And the answer is a resounding yes. The volatility of high-yield bonds comes from two major factors: market interest rates and credit quality. Market interest rates affect bond prices directly by raising the cost of issuance. Credit quality impacts the yield, which is why it is so important to understand credit quality before investing in bonds.
Bond quality varies across time frames and within companies. It is also affected by changes in liquidity. For instance, emerging markets with lower overall credit quality experience large increases in default rates as their financial conditions improve. As a result, investors must reduce overall portfolio exposure to these markets in order to reduce portfolio exposure to higher default risks investment projects.
One way to reduce the overall portfolio risk associated with bonds is diversification. Diversification across asset classes helps to spread risk and volatility to the maximum extent. A good example of a diversified portfolio is a mix of U.S. treasury and commercial mortgage-backed securities (CMBS). This type of diversified portfolio will offset higher default risks associated with high-yield mutual funds and bonds and provide additional insurance against credit risk. There are other types of bonds that make excellent candidates for inclusion in a diversified portfolio, including interest-bearing and tax-bearing commercial paper.
In addition to diversifying across asset classes, another way to reduce portfolio risk associated with high-yield investments is to purchase debt security or bonds with fixed interest rates. Although junk bonds typically have higher default risks than higher-quality bonds, they generally provide a reliable income stream in case interest rates are low. Debt security or bonds with fixed rates may also be used as a substitute for standard investment-grade bonds when the market value of the security is low due to global economic or political factors. Debt securities typically come with a longer maturity than high-yield investments and therefore incur less drawdown during periods in which market interest rates are negative.
Many high-yield bonds that are traded on secondary markets are sold using ‘leverage’ or buy-sell (also known as ‘put and call’) options. When selling through a cover-sell mechanism, fund managers can set a maximum price that they will pay for security if the bond’s market price moves below that maximum price. If a particular bond’s market price moves below the option price, the manager will need to purchase a position in the underlying instrument in order to satisfy the margin requirement. However, many fund managers may use a naked call strategy in which they would not pay a premium for the bond if the prices of the underlying instruments move lower than their option prices. Naked calls also carry less risk, since the managers do not commit to any position in the underlying instrument if the prices of the underlying instruments move below the strike price.
One of the advantages of investing in high-yield bonds is that they offer higher potential returns even in a bear market since the interest rates are usually close to historical averages. However, due to their high default rates, unfavorable market trends, and varying credit quality, high-yield investments may also pose significant risks. Traders should take time to research potential high-yield investment opportunities and perform due diligence on potential junk bonds and secondary market players before making direct investments.