Why credit risk is an essential value driver of high yield bonds

Why credit risk is an essential value driver of high yield bonds (Part 1 of 5)

Why credit risk is an essential value driver of high yield bonds

Credit risk and bonds

Bonds are highly sensitive to credit risk—other than U.S. Treasury securities, which are more prone to interest risk. Credit risk, also known as “default risk,” is the probability that an issuer may default on interest and principal payments. Credit risk hugely varies based on the issuer’s operational and financial stability.

U.S. Treasury securities commonly referred to as “Treasuries” are a virtually risk-free asset, mostly used as a benchmark to assess the credit-riskiness of the other fixed income securities available in the market. They are no different from any other bond class, except that in this case, the bond is backed by the full faith and credit of the U.S. government.

US Treasuries YTMEnlarge Graph

The U.S. government offers a range of Treasuries to meet investment needs, and the variation on the yield largely depends on their maturity. For example, Treasury bills (T-Bills) are essentially short-term low-risk bonds with a maturity period less than or equal to one year. T-Bills are auctioned weekly and issued in a set of one-, three-, six-, or 12-month maturity. Since these securities mature in such a short time, they have lower yields than U.S. Treasuries with higher maturity.

Remember: The higher the maturity, the higher the yield

Treasury notes (intermediate notes) are issued with maturities of three, five, seven, and ten years and Treasury bonds or long-term bonds with maturity ranging between 20 and 30 years. These bonds pay investors a fixed annual rate of return or coupon (normally paid semi-annually). When these securities are auctioned, they may sell at a price that translates to a yield-to-maturity higher or lower than that of the coupon.

For example, we can observe from the chart above that the U.S. two-year Treasury yield-to-maturity has been mostly in the range of 0.25% to its highest of 0.50% in September 2013. Meanwhile, the U.S. ten-year Treasury yield-to-maturity, which is widely used as benchmark for the Treasury market, has ranged between 2.5% and 3.0% in 2013. Typically, the more distant the maturity dates of the issue, the higher the yield on the bond.

Credit risk: A major concern for high yield bonds

The creditworthiness of the issuer is a large concern for high yield (HYG) bonds. This is because issuers are generally either a small corporation with an unproven track record or may be financially distressed midsize to large organizations having lower-grade credit ratings. The risk of default on the principal and interest payment is relatively high in this asset class. But also remember the basic principle of investing: the higher the risk, the higher the return. The same principle applies to the high yield bond, which offers relatively higher yields than the risk-free Treasury securities.

For example, the one-year Treasury security with a coupon rate of 0.25% issued at a par value (par value is equal to the face value of the bond, which is normally issued in a denomination of $1,000) will have a 0.25% yield hold until maturity. The high yield bond with similar maturity would give a higher coupon rate and essentially higher yield-to-maturity because of the high risk element.

The difference in the yield-to-maturity between U.S. Treasuries and high yield bonds with the same duration is known as “credit spread.” In other terms, “spread” is the risk premium of investing in high risk bonds. Essentially, spreads can differ widely with changes in the asset credit rating and yields. Yields are mostly the function of credit risk, which can be gauged through the credit rating on the bond.

We’ll discuss why and how this credit spread differs between the two asset classes, but before that, let’s have a look at the factors that contribute to riskiness in the next part of this series.

To learn more about U.S. Treasuries, see the Market Realist series Why investors should look at floating rate notes as an option.

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