High Yield Investing: Corporate Bonds versus Equities
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
A company can issue debt (bonds) or equity (stock) as they look to gain access to capital markets. Investors then have the options to buy either the bonds or stock. It often seems that novice investors immediately think of stocks when they think of the concept of investing, but it is also important to understand just what a corporate bond is and how it is structurally different than equities. And with those differences, we see certain advantages of high yield corporate bond versus stock investing.
A bond is a loan. A bond investor is akin to a bank, giving the company money now with the expectation of getting paid back at a certain date in the future and earning an interest rate for loaning the money over the outstanding period. But instead of this loan staying in the hands of one entity, it is then routinely divided and traded among investors over the life of the loan. Equity, on the other hand, is ownership in the company, but doesn’t include an obligation to return the money paid for it in the future.
This US corporate bond market is a huge market, nearly $9 trillion1, with about $1.5 trillion of that in the high yield bond (non-investment grade) category. If you include the large numbers of companies based overseas that issue US dollar bonds, the US dollar high yield bond market is nearly $2 trillion.2 And even if corporate bonds are not the first thing one thinks of when investing, this is an easily accessible market. While high yield bonds have an active secondary market of trading, it is not done over an “exchange.” Rather, bonds trade in a negotiated market, where trading relationships are important for managers in sourcing product. Bonds generally trade in larger increments, thus, it can be hard to trade smaller batches of bonds, and investors won’t necessarily get the best pricing. Because of this, pooled vehicles, such as high yield bond mutual funds and exchange traded funds, have become popular means by which retail investors can gain access to the asset class, with the funds holding a diversified underlying portfolio of individual bond holdings.
As follows, there are a number of structure features and benefits investors should be cognizant of as they consider the right asset mix between equity and corporate bond holdings:
- Consistent Income: Corporate bonds have a set maturity date and an interest rate upon issuance, creating a contracted stream of income for bondholders. Bonds typically pay this interest twice per year but trade with accrued interest, meaning that a buyer can buy the bond anytime before the paydate but would have to pay the seller the accrued interest up to that point. Equities aren’t required to pay dividends—most actually don’t pay a dividend leaving investors to entirely rely on the stock price movement to create value/returns. And for the stocks that do pay dividends, these dividends can be cut or eliminated by the company at any point as they are not contractual obligations but rather decisions subject to the Board’s discretion.
- Finite Exit Strategy: Bonds are issued with a maturity date, which is the date at which the issuer is obligated to pay the bondholder back the “par value” of the bonds. This finite exit strategy via maturity is one of the greatest features that we see for bonds versus equities, especially for value investors. If you are an active investor and identify a security as undervalued, you aren’t left waiting in perpetuity for the market to realize that value. With a bond, barring a default, you know that the maturity date gives you a final date at which point you’d realize that value, and that value may even be realized earlier via the call dates as we discuss below.
- Capital Gains Potential: If a bond is purchased/trading at a discount to the par value, it may appreciate in value as it moves toward that maturity date, providing investors with capital gains opportunity. However, most of the time investors don’t have to wait until maturity for a bond to be paid back. Companies generally choose to refinance or redeem their bonds at some point prior to that maturity date, but must typically pay the bondholder a “call premium” above par (pre-payment penalty) to do so. This provides the opportunity for investors to earn a price even above par. A potential investment return can be easily calculated for a bond using the interest rate and maturity date or earlier call dates and prices, so investors can have a clearer picture of their potential return prospects.
- Priority Capital Structure Ranking: The debt/bonds rank ahead of stock/equity in a company’s capital structure. This ranking means that bondholders have a priority claim on the company’s assets and get paid first in the event of a default or bankruptcy. With this priority, the debt in a given company is considered less risky than the stock of the company.
- Historically Lower Volatility/Risk Adjust Outperformance: As noted above, high yield bonds benefit from their consistent income and capital gains potential and the historical return profile of high yield bonds has been similar to that of equities but with 30-40% less risk (as measured by standard deviation), leading to the high yield bond market’s risk adjusted outperformance versus equities.3
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risks and uncertainties, as well as the potential for loss. High yield bonds are lower rated bonds and involve a greater degree of risk versus investment grade bonds in return for the higher yield potential. As such, securities rated below investment grade generally entail greater credit, market, issuer, and liquidity risk than investment grade securities. Interest rate risk may also occur when interest rates rise. Past performance is not an indication or guarantee of future results. The index returns and other statistics are provided for purposes of comparison and information, however an investment cannot be made in an index.