Why Are High-Yield Corporate Bond Funds Falling?
The decline of high yields in many "junk" or speculative bond funds reflects the fact that bond yields are a function of credit risk, maturity and the general level of interest rates. Each of these factors is crucial to creating the supply and demand for such funds. During the credit crisis that came to a head in 2008 and 2009 there was widespread aversion to weak credits, causing yields of existing bonds to rise sharply. Yield relationships have returned to normalized levels.
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Changing Economic Conditions
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When interest rates rise bond prices decline. This inverse relationship reflects the fact that two bonds with the same credit and maturity value but different coupons can only be made of equal value by a price differential. Bonds with different credit qualities will also have different yields to compensate the investor for the added risk of holding lesser quality bonds. Bonds are generally of two broad investment categories: investment or speculative grade quality. Investment grade refers to bonds of high-quality assets and cash flow to make regular interest payments. Speculative or junk bonds may currently have adequate cash flow but face credit challenges due to few assets, a challenging economic environment, and an inability to finance additional debt if needed. Speculative bonds have high yields and are extremely volatile in price.
Risk Aversion
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During the economic weakness following 2007 the difference in yields between investment-grade and speculative-grade bonds widened sharply. The cause of the problem was not excessive issuance by corporate issuers but an unwillingness by investors to buy speculative credits and a strong preference by investors to hold short, less volatile, maturities of corporate bills and notes rather than bonds. It was these factors, coinciding with a loss of confidence in other markets, noticeably stocks, that resulted in corporate bond yields spiking sharply.
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Lack of Supply
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Since the worst of the crisis, few high-yield bond issuers have regularly entered the fixed-income markets for bond sales. Speculative issuers, some of who are now bankrupt, instead find it in their financial interest to issue stock instead of bonds. Equity issuance lowers the risk profile of a company since stock dividends are optional, the lack of bond issuance lowers interest expense and companies are avoiding corporate expansion that does not provide immediate cash flow. An accumulative Federal Reserve Bank has kept interest rates at low levels, providing investors little yield. The combination of low interest rates, falling speculative supply and rising investor demand for higher yield paper has reduced yields significantly.
Early Redemption
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Issuers of high yielding bonds have also found it profitable to retire before maturity outstanding bonds with lower rates of interest. Nearly every high-yield bond has a call feature, giving the issuer the right but not the responsibility to redeem an outstanding bond issue prior to maturity. Issuers redeem the outstanding bonds while issuing new bonds at lower interest rates. The net savings in interest accrues to the issuer with the bond investor forced to reinvest monies in the lower interest rate environment.
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