Suppose you're nearing retirement, and you're looking at some investment options. Because the memory of 2008 is still fresh in your mind, you feel nervous about investing in stocks. You look at Canadian government bond yields, and you shake your head - long term bonds barely yield 2.5%.
Can't you do better?
So you look around, and you come across ETFs that invest in high yield bonds. The interest on these ETFs is significantly higher than on government bonds, often offering above 4.5%. With these ETFs, you can finally enjoy the dual benefit of safety and high yields.
Or can you?
As with anything else in investing, there is no free lunch. When an investment offers you better returns, you can bet your bottom dollar that it comes with costs. In this article, I'll explain what those costs are, and what it would take for those costs justify the higher returns.
Why The High Yield?
In general, the reason high yield bonds (a.k.a. "junk" bonds) have higher yields is because of their higher default risk.
On the other hand, Government of Canada bonds carry very low default risk. The government has a history of honouring their debt obligations, and they can theoretically raise taxes (or print money!) if they want to pay down some debt. As such, Government of Canada bonds are very safe bonds.
Corporations can't do that and so bonds issued by troubled corporations carry much higher default risk. For example, Centric Health (Ticker CHH.TO) bonds have a yield of roughly 12.5% per year, which is some 11% higher than the Government of Canada bond of similar maturity. If investors felt sure that Centric would pay back its debt in full, investors would buy more Centric bonds, pushing bond prices up and bond yields down (To see how this works, please read our free book). By refusing to buy Centric bonds despite the high yield, investors are signalling that they don't feel very confident about the company's prospects.
Rationally speaking, the difference, or the 'spread' between a high yield bond's interest rate and a very safe bond's interest rate depends on 3 factors: Probability of default, Recovery rate, and Risk premium.
I'm betting you intuitively understand probability of default, so let me explain what a recovery rate is.
When a corporation defaults on a bond and declares bankruptcy, the bond holders have a claim on the assets of the corporation. For example, if the corporation owns some buildings, it has to sell them and give the proceeds to its bond holders. If bond holders recover 30% of the principal of the bond from the corporation, then we refer to that 30% as the recovery rate.
Finally, unlike investing in very safe bonds, investing in high yield bonds is a bit of a gamble, as you can lose more than you can potentially earn. Therefore, investors demand higher yields to compensate for this extra risk. This is the risk premium.
We can estimate what the spread between a very safe bond and a riskier bond should be using the following simplified formula:
Spread = [Probability of Default] * (100% - [Expected Recovery Rate]) + [Risk Premium]
The formula essentially calculates the expected amount of loss from investing in the bond, plus a little extra to compensate for the higher risk (As an aside, the real formula is more complicated, but I've chosen a simpler version in order to illustrate). For example, for us to arrive at the 11% spread for Centric Health, we might assume something like a 12% chance of default, a 30% expected recovery rate and a 2.5% risk premium (i.e. 0.12 * (1.00 - 0.3) + 0.025 = 0.11).
Why ETFs Make Sense For High Yield Bonds
Now, think about the Centric Health example for a minute. Does that sound like a good deal to you? You have a 88% chance of earning 12.5% in a given year, but you have a 12% chance of losing 70% (because it's 100% - 30%). In other words, you have a high chance of gaining a little, and a small chance of losing big. Even though you're getting some compensation for taking higher risks, this might not sound like such a great deal.
Thankfully, there is a better way to invest in high yield bonds, and that's through ETFs. When you buy a high yield bond ETF, you essentially get to invest in at least dozens of different bonds. Therefore, a default by any one of these bonds won't significantly affect the overall ETF.
Currently, I know of 4 ETFs in Canada that offer investors exposure to high yield bonds. They are: Advantaged U.S. High Yield Bond Index ETF (CHB), iShares Canadian HYBrid Corporate Bond Index ETF (XHB), iShares U.S. High Yield Bond Index ETF (XHY) and BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ZHY).
Out of the four, three of them invest in U.S. high yield bonds, while only XHB invests solely in Canadian bonds. Normally, holding foreign bonds is a no-no because currency risks make them significantly more dangerous. However, the ETFs that invest in U.S. bonds are currency hedged, so you don't have to worry too much about currency risks.
Although investing in ETFs are "safer" than investing in individual bonds, it's still not as safe as investing in government bonds. This is because high yield bond defaults tend to come in clumps, such as during a recession.
When High Yield ETFs Are A Good Deal
Now that we know about our options, let's discuss the all important question - Should you buy them? To answer this, you should consider a few things.
Earlier in this article, I introduced a simplified formula for the 'spread' and said that the formula should dictate what the spread should be, rationally speaking. However, as I keep repeating on this site, the world is not rational. As a consequence, the spread is sometimes higher than it should be, while at other times, it's lower than it should be.
Let's examine the facts. According to a Moody's report, from 1987 to 2007, the default rate on high yield bonds averaged roughly 4 to 5% per year. During some years, the rate was higher while in other years, it was lower. During the same time, the recovery rate averaged about 35 to 40%. Historically, the spread between high yield bonds and very safe bonds averaged around 5%, which means the risk premium averaged around 2% historically.
This means if we can buy high yield bond ETFs when the spread is above 5% per year, we'd be getting a better deal than investors have historically, assuming historical probability of default and recovery rates. Conversely, if we can only buy high yield ETFs at a lower than 5% spread, we'd be getting a worse deal.
The Spread Today
So where is the spread at today? Unfortunately, I have bad news on this front.
Today, the average U.S. high yield bond has a spread of just 3% above the very safe U.S. government bonds, a historic low. The Canadian High Yield Bond ETF yields just 4% while the Government of Canada bonds yield roughly 2%, meaning that the spread is just 2% for the ETF. The Canadian dollar hedged U.S. bond ETFs don't fare much better, with all of them having roughly 2.5% spread over government bonds.
Now, this doesn't necessarily mean that high yield bonds are a bad deal at this rate. If you think these high yield bonds will default far less often than they have in the past, you might see these ETFs as good value. However, you'd have to have a very good reason for believing such things, since it will cost you otherwise.
In summary, I personally think it's a bad time to get into high yield bonds. The spread between high yield bonds and very safe bonds is at historical lows, and if default rates go back to the long-term average, investors in these ETFs will get hurt. That said, I believe there will be a time in the future when the spread becomes large enough to warrant a closer look. I'll keep an eye on them for MoneyGeek's members.