Who should be buying high yield bond funds

The intense levels of geopolitical volatility have sent bond yields up to some of their highest levels since the 2007/8 crash, and investors have been moving into the space as a result to try and capture them.

Bond funds in general saw their strongest monthly inflows since June 2023, according to Calastone, a fund transaction network.

Indeed, May alone saw the highest month of new money since the study started in 2018.

Unmasking the bond vigilantes

Capturing high yields is one of the big pulls for investors into fixed income – evidently – and some might assume that simply picking a ‘high yield’ bond fund neatly fills in that gap. But these assets come with some risk trade offs investors should be aware of before taking the plunge.

The trade-off for a higher yield is higher risk

While bonds are lower risk than equities, they still have their own spectrum of risk and several factors determining that. In fixed income, they're:

• Default risk: if the issuer fails to pay interest or repay the loan (bond market jargon for not paying back the money they owe)
• Credit rating risk: high rating is usually BBB or above but high yield bonds are sub-investment grade and often referred to as ‘junk bonds’
• Market risk: do they behave more like shares during periods of market stress?

At the ‘safer end’ are government bonds, such as UK gilts or US Treasuries. These are deemed less risky because it’s less likely for a major government to default.

Check whether your bonds are actually doing their job

Next come investment grade corporate bonds, issued by financially stronger companies, and act as a stronger diversifier to equities as they’re more uncorrelated.

High yield bonds come at the riskier end because they are issued by companies with weaker credit ratings and behave more like shares than other bonds.

Which investor suits high yield bonds?

What appeals to investors is the higher income these types of bonds offer, which is the compensation for taking on higher risk.

Remember, no asset is risk-free. Equities sit at the top end of the spectrum and cash at the bottom with low risk, so someone comfortable to take more risk in their portfolio and using bonds to generate a higher income may consider buying a high yield bond fund.

We’ve mentioned funds but you can buy individual bonds, however, it’s not the most common way to invest in bonds because owning just a handful of individual options doesn’t give you as much diversification as a fund, where you’ll have exposure to a multitude of different options.

It’s worth nothing that it isn’t just funds in the namesake sector which can invest in high yield bonds, some strategic bond funds can too but for the purposes of this analysis, we’re just going to focus on names in the ‘high yield bonds’ sector.

High yields and interest rates

Another characteristic of high yield bonds is that they tend to have relatively short maturities, usually three to five years.

This means that changes in interest rates don’t tend to affect them as much as with long-dated Treasuries or gilts say, so with evolving outlook for central bank’s policy this year as inflation creeps back into the economy investors have opted for shorter dated bonds.

But again, this shorter maturity is tied up with high yield bonds being more risky, as the companies issuing them are less able to borrow money for long periods of time.

How much yield can you get?

Comparing the yields on offer, the United States 10-Year Treasury Note - which is used as the bellwether of fixed oncome markets - currently offers a yield of 4.57%.

This has moved up since the pandemic, when long-dated yields were less than 0.1% yield. US 10-Year Treasury yields starting moving into the 4% realm in 2022, data from World Government Bonds shows.

For comparison, the industry standard benchmark for US junk bonds, the ICE BofA US High Yield index, is at approximately 7.2%%, but is this a good deal?

What matters when comparing high yield bonds to investment grade bonds is the yield spread, which is the difference between the yields of two different bonds.

It's often used to calculate the ‘risk reward’ ratio between benchmark level bonds such as a 10-Year Treasury and shorter dated options, including high yield bonds, sometimes referred to as junk bonds.

If one bond yields 3% and another yields 1%, the yield spread is 2% - or 200 bps (basis points) - and the wider the spread generally, means investors think one bond is much riskier than the other. The riskier bond has to offer a higher yield to attract buyers.

At present, the spread between the US-10 Year and ICE index is around 2.4%, similar to the US 10-Year and 2-Year spread which is 2.69%. The latter running is below the long-term averages and means that right now, investors are not having to take on as much risk as they were this time last year to buy short dated or junk bonds.

The yield on the ICE high yield index is currently 7.2%. You can currently get funds offering even more yield than this. The Invesco High Yield UK Income fund for example, which is on AJ Bell’s Favourite Funds list, is offering a 7.3% yield, while the T. Rowe Price Global High Yield Opportunities Bond Fund has 7.41%. High yield tracker funds and ETFs are offering yields around 6% to 7% as well.

Spreads can widen and shrink rapidly though depending on the economic outlook.

Tighter spreads mean that investors are not being as well compensated for higher risks on high yield bonds.