The term high-yield bonds is something of a misnomer.

Consistent with the words high yield, these debt securities offer higher income potential than high-quality or investment-grade bonds as compensation for their higher risk. We believe the bonds part of high-yield bonds, however, can mislead. High-yield bonds do not behave like their investment-grade counterparts, the kind most investors think of when they consider bonds. And despite a popular perception, the primary risk to high-yield bonds is not interest rate risk, or the tendency of bond prices to fall when interest rates rise. Their primary risk is credit risk, or the ability of issuers to repay their debts.

More Like Stocks Than Investment-Grade Bonds
In reality, the correlation between high-yield bonds and U.S. Treasuries has been erratic and often negative. Put simply, high-yield bonds don’t exactly track every Treasury zig and zag. The last period of high correlations between high-yield bonds and Treasuries occurred in thelate1990s. It lasted for roughly three years.

High-yield bonds’ correlations with stocks, on the other hand, have been more positive, and usually higher than their correlation with Treasuries. This suggests that high-yield bond investors should focus on risks traditionally associated with stocks—risks that include any significant deterioration in economic conditions or corporate profitability.

Evidence of high-yield bonds’ closer connection to stocks is widespread and statistically demonstrable. For example, such bonds’ “betas”—essentially, their volatility levels in relation to other assets—are more like those of broad stock market indices than investment-grade bond market indices. It is also true that “duration”—the weighted average time until all of a bond’s scheduled cash flows have occurred and a common approximation of bonds’ sensitivity to interest rates—tends to overstate high-yield bonds’ actual rate sensitivity.

Perhaps more telling than the numbers is investor behavior. We believe high-yield investors, as a group, often behave like stock investors, especially when high-yield bond prices decline. Ultimately, the high-yield bond holder can claim the assets of the bond-issuing company, becoming de facto stock investors. Interestingly, few high-yield bonds ever mature. They get called, exchanged and upgraded to investment grade, and, occasionally, they default. They seldom mature, much as equity shares never mature. A key difference between high-yield bonds and equities is the obligation of bond issuers to pay interest on their borrowings and to repay the principal. Equity issuers are not obligated to pay dividends.

Placing Rising Rate Fears In Context
Interest rates may climb because economic growth is accelerating or in reaction to higher inflation. In either case, the central bank might be reacting to an environment that is generally positive for credit risk. In the first case, the risk of default, or non-payment by bond issuers, should be falling. In the second case, borrowers may inflate their way out of their debt burdens, assuming they are primarily of the fixed-rate variety. Some industries and companies may be disadvantage din either scenario, but on average and in aggregate credit metrics should be improving.
 
Over a horizon of one year or more, we believe it would take an interest rate increase larger than investors presently expect to create negative total returns on diversified pools of well-chosen high-yield bonds. (Interest rate expectations can be inferred from the current slope of the yield curve.) Indeed, we estimate that high-yield bond total returns would be positive in the face of even a 1.50 percentage point increase in the yield of the five-year U.S. Treasury. This expectation does not assume any decrease in credit spreads—something we might typically expect as the economy improves. Our confidence in the ability of high-yield bonds to deliver positive total returns reflects a combination of recent Treasury and high-yield bond yields as well as our understanding of high-yield issues’ true rate sensitivity.
 
The Primary Risk And Opportunity In High-Yield Bonds
One aspect of high-yield bonds that has not changed over the three decades since they first attracted investor attention is their higher sensitivity to stocks—and, by extension, the factors that influence stocks. Primary among the factors that affect both stocks and high-yield bonds are the health of the corporate sector and the wider economy.
 
In other words, the primary risk and opportunity for high-yield bonds continues to be credit. If the economy is improving and corporations are benefiting from that improvement, high-yield bond investors should be able to harvest the higher coupons offered by the asset class. Over time frames of 18 months or more, there should be only a small risk that price depreciation will fully offset the bonds’ coupons, resulting in negative total returns. On the other hand, if the economy stalls, enters a recession or corporate health weakens for other reasons, then high-yield bonds will become more vulnerable.
 
To fret about a rise in interest rates is to worry about the wrong type of risk, in our opinion. If stock-like concerns have more impact—and they do—high-yield bond investors should concern themselves with stock-like risks.
 
Greg Hopper is Head of the Global High Yield strategy on the North American Fixed Income team at Aberdeen Asset Management in New York.