High Yield and Emerging Market Bonds

High yield bonds are issued by domestic companies whose creditworthiness has been judged to be below "investment grade" by one or more of the major bond rating agencies (e.g., Standard and Poor's, Moody's, or Fitch). These agencies use a letter system to define their credit ratings. AAA is the highest rating, followed by AA, A, and the BBB, which is the lowest "investment grade" rating. Issues rated below BBB are termed "high yield" (or, less attractively, "junk") bonds. Emerging market bonds are issued by companies and governments (though usually by the latter) located in what are generally viewed to be less developed or "emerging market" countries. These bonds are usually, but not always denominated in U.S. dollars, Euro, Yen or Pounds rather than the local currency of the issuing country. Because few, if any emerging market bonds have attained investment grade ratings, we are including them in this section. Both high yield and emerging markets bonds have higher credit risk than investment grade bonds. When times are difficult, they are more likely to default, and cause a loss of capital. As a result, the real returns they produce tend to go down when economic conditions worsen. In this regard, they are similar to equities, and unlike investment grade bonds. For example, in the United States between 1971 and 2002, the correlation of real annual returns between the equity market (measured by the Wilshire 5000 Index) and the investment grade bond market was .22, while the correlation between equities and high yield bonds was .56.

Here is some additional data about the real returns on this asset class in the United States, in comparison to investment grade bonds and equities.

Real Returns 1971 to 2002 in the United States of America

	Average Annual Return	Standard Deviation	Skewness	Kurtosis
Domestic Investment Grade Bonds	3.82%	5.40%	.41	4.20
Domestic High Yield Bonds	4.40%	9.01%	(.31)	3.63
Domestic Equities	7.26%	16.29%	(.49)	1.96

This table makes some key points about domestic high yield bonds as an asset class. Statistically, they look more like equity than like debt. More to the point, their standard deviation probably understates their relative riskiness, as their returns are negatively skewed with unusually fat tails. In other words, big downside surprises are much more likely than with investment grade bonds. Because these downside surprises are likely to happen when the economy is declining and equities are also turning down, we are left with a simple question: why would you want to invest in high yield bonds instead of equities?

The same arguments can be made for emerging market bonds, which are basically the international equivalent of domestic high yield bonds. Their limited track record seems to suggest that they also are highly volatile and likely to generate negative returns when equity markets are turning down.

Our arguments in favor and against the use of high yield and emerging market bonds can be summarized as follows:

Market Condition	Normal	Inflation	Deflation
Reasons to Invest in High Yield Bonds	Modest correlations with most asset classes. Highest (for US) are .56 with US equities and .43 with European equities	Hard to think of one.	Both interest payments and capital values increase in real terms
Reasons Not to Invest in Domestic Investment Grade Bonds	Equity provides higher returns with similar degree of risk	Avoid declines in the real value of interest and principal payments	Credit quality of these bonds to begin with, and default rate may rise rapidly in a downturn.