Higher current income from these bonds can
help buffer price volatility.
Current low interest rates and low yields on more
conservative fixed-income investments have left many investors
searching for higher yields. If you fall into this camp, you
may want to consider the relatively higher yields associated
with non-investment-grade bonds, also known as high-yield
bonds. These securities, however, aren’t for
everyone—especially those investors who are risk averse.
But, if you are an investor who can tolerate a higher level of
risk and volatility, they may offer some advantages.
Before you do anything, however, you need to understand:
- how high-yield securities work,
- why now may be a prudent time to learn more,
- the type of investor they may be appropriate for and,
- how to invest in them.
What are high-yield securities?
High-yield securities are viewed by both analysts and
investors as riskier than those issued by companies with
stronger balance sheets and higher credit ratings.
Credit-rating agencies—such as Standard and Poor's,
Moody's, and Fitch Ratings—evaluate the ability of public
companies, governments, and other borrowers to make income and
principal payments to their debt holders. The debt of those
organizations best prepared to do so is rated
"investment-grade" (BBB and higher), while the debt
of those most vulnerable to default is rated
"non-investment-grade" (BB and lower).
Distressed companies and leveraged companies—due in large
part to their relatively high ratio of debt to equity—tend
to struggle more than better-capitalized companies during
economic downturns. To compensate for taking on increased
risk, such as default risk, the debt of these companies
typically offers higher yields, hence the term "high
yield."
There are three main types of securities issued by
non-investment-grade companies:
- Leveraged (or "floating rate") loans;
- High-yield bonds; and
- Leveraged-company stock (equity in companies that issue
non-investment-grade debt or have a leveraged capital
structure).
To put the risk associated with high-yield investments into
perspective, the chart below compares the volatility of
high-yield debt with that of investment-grade debt, as well as
leveraged-company stocks versus other domestic and foreign
stocks. You can see that high-yield bonds and loans fall into
the medium risk category, while leveraged-company equities are
rated very high risk.
However, although high-yield bonds are fixed-income
securities, they often behave more like equities during market
declines. For example, in 2008, the Bank of America Merrill
Lynch High Yield Master II Constrained Index fell 26.1%.
Although this was the worst calendar year return for
high-yield bonds in the post-World War II era, investors
should understand that high yield can suffer large losses.
A prudent time to consider high yield?
There are two reasons to consider investing in this sector:
1. High current income
With the 10-year Treasury bond yield hovering in the low 3%
range through mid-July, the average yield for taxable
high-yield bonds was 8.73%,1 a difference (or
spread) of nearly six percentage points. As the chart below
shows, although this spread has narrowed over the past 12
months, it’s still above historical norms.
2. High coupon can mitigate price declines
In addition to receiving income, high-yield investors have the
potential for capital appreciation if the price of their bond
or bond fund improves. The combination of the relatively high
yields and the potential for capital appreciation can lead to
better returns for high-yield bonds as economic conditions
improve. If they don’t, high yields can protect against a
certain amount of price depreciation.
Additionally, the high-yield asset class has historically
been less sensitive to rising rates compared with other
fixed-income asset classes. This is partly a result of its
equity-like components and because many high-yield issuers
have fixed-interest costs and have the potential to benefit
from an improvement in pricing power.
For example, when the economy recovered from the decline of
2000–2002, the total 2003 calendar-year return of high-yield
bonds was quite strong, similar to what it had been from
year-end 2008 to year-end 2009. (See chart below.)
And, in a reversal of 2008's deep losses, the one-year
high-yield bond return for calendar-year 2009 was nearly 60%.
As of June 30, 2010, the one-year return was about 28%.2
The default rate, too, has been steadily declining and is
not generally expected to negatively impact the asset class in
the coming months. It is important, however, to remember that
past performance is no guarantee of future results.
Who may want to consider high yield?
An allocation to high-yield securities may be appropriate
for an investor who is well diversified, risk tolerant, and
has a long-term investment time frame. Typically, these types
of securities also appeal to investors looking for additional
income and the potential for capital appreciation. Of course,
investors need to do their own research.
Tom Hense, chief investment officer for Fidelity's
high-yield investment group, encourages leveraged-company
investors to seek the widest possible diversification across
industry sectors and individual issuers.
Next steps
There are many ways to invest in the high-yield bond asset
class, including mutual funds, exchange-traded funds (ETFs),
or individual high-yield bonds. Given the inherent credit risk
associated with these types of bonds, we believe it is
important to diversify across many different issuers from
different industries. For the average investor, it may be
appropriate to seek this type of diversification through a
diversified investment vehicle like a mutual fund or ETF.
Before investing in any
mutual fund, please carefully consider the investment
objectives, risks, charges, and expenses. For this and other
information, call or write Fidelity for a free prospectus or,
if available, a summary prospectus. Read it carefully before
you invest.
1. As measured by the
average taxable bond in the Bank of America Merrill Lynch High
Yield Master II Constrained Index, as of July 15, 2010.
2. Ibid.
Investment decisions should be based on an individual's own
goals, time horizon, and tolerance for risk. Past performance
is no guarantee of future results.
Although bonds generally present less short-term risk and
volatility than stocks, bonds do contain interest rate risk
(as interest rates rise, bond prices usually fall, and vice
versa) and the risk of default, or the risk that an issuer
will be unable to make income or principal payments.
Additionally, bonds and short-term investments entail greater
inflation risk, or the risk that the return of an investment
will not keep up with increases in the prices of goods and
services, than stocks. Lower-quality fixed-income securities
generally offer higher yields but also carry more risk of
default or price changes due to potential changes in the
credit quality of the issuer.
Leverage can magnify the impact of adverse issuer,
political, regulatory, market, or economic developments on a
company. In the event of bankruptcy, a company's creditors
take precedence over the company's stockholders.
Diversification does not ensure a profit or guarantee
against loss.
ETFs are subject to market fluctuations of their underlying
investments. ETFs may trade at a discount to their net asset
value (NAV).
The Bank of America Merrill Lynch U.S. High Yield Index is a
market capitalization-weighted index of U.S. dollar
denominated below investment grade corporate debt publicly
issued in the U.S. domestic market. Qualifying securities must
have a below investment grade rating (based on an average of
Moody’s, S&P and Fitch) and an investment grade rated
country of risk. In addition, qualifying securities must have
at least one year remaining to final maturity, a fixed coupon
schedule and at least $100 million in outstanding face value.
Defaulted securities are excluded.
The Bank of America Merrill Lynch U.S. High Yield Constrained
Index is a modified market capitalization-weighted index of
U.S. dollar denominated below investment grade corporate debt
publicly issued in the U.S. domestic market. Qualifying
securities must have a below investment grade rating (based on
an average of Moody’s, S&P and Fitch) and an investment
grade rated country of risk. In addition, qualifying
securities must have at least one year remaining to final
maturity, a fixed coupon schedule and at least $100 million in
outstanding face value. Defaulted securities are excluded. The
index contains all securities of The BofA Merrill Lynch U.S.
High Yield Index but caps issuer exposure at 2%.
All indexes are unmanaged and performance of the indexes
includes reinvestment of dividends and interest income unless
otherwise noted. Please note that you can not invest directly
in an index.
All references to the following fixed-income security asset
classes and related performance and statistics are represented
by the following indexes unless otherwise noted:
a. Barclays Capital® (BC) 3-Month U.S. Treasury
Bill Index is an unmanaged market value–weighted index of
investment-grade fixed-rate public obligations of the U.S.
Treasury with maturities of 3 months, excluding zero coupon
strips. BC U.S. Intermediate Government Bond Index is an
unmanaged index composed of all bonds covered by the Barclays
Capital Government Bond Index with maturities between one and
9.99 years. Total return comprises price
appreciation/depreciation and income as a percentage of the
original investment. Indexes are rebalanced monthly by market
capitalization. c.1. Bank of America Merrill Lynch U.S. High
Yield Master II Constrained Index is an unmanaged market
value–weighted index of all domestic and Yankee high-yield
bonds, including deferred interest bonds and payment-in-kind
securities. Issues included in the index have maturities of
one year or more and have a credit rating lower than
BBB-/Baa3, but are not in default. The Bank of America Merrill
Lynch U.S. High Yield Master II Constrained Index limits any
individual issuer to a maximum of 2% benchmark exposure.
Returns shown for the Bank of America Merrill Lynch U.S. High
Yield Master II Constrained Index for periods prior to
December 31, 1996 (its inception date) are returns of the Bank
of America Merrill Lynch U.S. High Yield Master II Index. c.2.
Standard & Poor's/Loan Syndications and Trading
Association Leveraged Performing Loan Index (S&P/LSTA) is
a market value–weighted index designed to represent the
performance of U.S. dollar–denominated institutional
leveraged performing loan portfolios (excluding loans in
payment default) using current market weightings, spreads, and
interest payments. d.1. Standard & Poor's 500 Index
(S&P 500® Index) is an unmanaged market
capitalization–weighted index of 500 common stocks chosen
for market size, liquidity, and industry group representation
to represent U.S. equity performance. d.2. Morgan Stanley
Capital International Europe, Australasia, Far East Index (MSCI®
EAFE® Index) is an unmanaged market
capitalization–weighted index of equity securities of
companies domiciled in various countries.
The MSCI EAFE is designed to represent the performance of
developed stock markets outside the United States and Canada
and excludes certain market segments unavailable to U.S.-based
investors. The Net version of the MSCI EAFE adjusts for
withholding taxes applicable to Massachusetts Business Trusts.
e. Credit Suisse (CS) Leveraged Equity Index is an unmanaged
market-weighted index designed to represent securities of the
investable universe of the U.S. dollar–denominated
high-yield debt market.
These opinions do not necessarily represent the views of
Fidelity or any other person in the Fidelity organization and
are subject to change at any time based upon market or other
conditions. Fidelity disclaims any responsibility to update
such views. These views may not be relied on as investment
advice and, because investment decisions for a Fidelity fund
are based on numerous factors, may not be relied on as an
indication of trading intent on behalf of any Fidelity fund.
