High-Yield Bonds and the Credit Cycle
Understand how high-yield bonds behave across the credit cycle and calculate portfolio returns under different default scenarios.
What you will learn
- What high-yield bonds are, including fallen angels and rising stars.
- The four phases of the credit cycle and how spreads and defaults behave in each.
- How to calculate a high-yield portfolio's return under different default and recovery assumptions.
- Why high yield behaves partly like equity, and what that means for diversification.
Explanation
High-yield bonds (also called speculative-grade or, informally, "junk" bonds) are rated BB+ (Moody's: Ba1) or lower. Issuers are often companies with high debt, a short history, cyclical business or weak profitability. Typical features:
- Shorter maturities (often 5 to 8 years at issue) and higher coupons than investment-grade bonds.
- Frequent call options, so the yield to worst (lesson 5) is the more honest yield measure.
- Large minimum trading sizes for many issues (often €100,000 face value), which makes direct purchases difficult for private investors. Check the minimum size before planning to buy.
A fallen angel is a bond downgraded from investment grade to high yield. Because some investors must or prefer to sell such bonds, prices can fall more than the change in credit risk alone would justify. A rising star is the opposite: upgraded into investment grade.
The credit cycle
The credit cycle describes how easy borrowing is over time. It is linked to, but not identical with, the business cycle.
| Phase | Lenders and issuers | Spreads | Defaults |
|---|---|---|---|
| Expansion | Easy credit, rising leverage, weaker covenants ("covenant-lite" deals) | Narrow | Low |
| Late cycle | Aggressive deals, debt-financed buyouts and dividends | Narrow, starting to widen | Low but rising |
| Downturn | Credit tightens; weak issuers cannot refinance | Widen sharply | Rising, peaking after spreads |
| Repair | Debt reduction, restructurings, cautious lending | Narrowing from wide levels | High but falling |
Two points matter for investors. First, spreads usually move before defaults: the market prices expected losses in advance, so prices can fall sharply while actual defaults are still low. Second, historical default rates for high-yield issuers have varied greatly between calm years and recessions. Rating agencies publish annual default studies; use those for real figures rather than one "average" number.
Equity-like behaviour
High-yield bond prices depend strongly on the issuer's business doing well, so they often fall at the same time as stocks. Their interest-rate duration is usually short, but their spread duration (price sensitivity to a change in credit spread) matters more. In a stock-market sell-off, high yield tends to give much less protection than high-quality government bonds.
A refinancing wall (a large amount of debt maturing in a short period) is a common warning sign: issuers that borrowed cheaply may have to refinance at much higher coupons.
Worked example
Hypothetical example: a portfolio of 100 high-yield bonds, €1,000 face value each (€100,000 in total), bought at par, all with a 7% coupon. Horizon: one year. Assumptions: defaulted bonds pay no coupon and recover 35% at year-end; surviving bonds are still worth par at year-end. Fees, bid–ask spreads and taxes are excluded.
| Scenario A: 2 defaults | Scenario B: 8 defaults | |
|---|---|---|
| Coupons from survivors | 98 × €70 = €6,860 | 92 × €70 = €6,440 |
| Value of survivors | 98 × €1,000 = €98,000 | 92 × €1,000 = €92,000 |
| Recovery on defaults | 2 × €350 = €700 | 8 × €350 = €2,800 |
| End value | €105,560 | €101,240 |
| Return | +5.56% | +1.24% |
Now add the market effect. Suppose in scenario B spreads widen by 3 points and the surviving bonds have a spread duration of 3.5. The estimated mark-to-market loss is −3.5 × 0.03 = −10.5%, or about −€10,500 on €100,000. In a downturn, the price loss can be much larger than the actual default losses within the year.
Common mistake
Practice activity
On paper, with hypothetical data: 50 high-yield bonds, €2,000 face value each, bought at par with an 8% coupon. Over one year 3 bonds default and recover 40% at year-end; defaulted bonds pay no coupon; survivors are worth par. (a) Calculate the end value and return. (b) Estimate the additional price effect if spreads widen by 2 points and spread duration is 3.0.
Show solution
(a) Invested: 50 × €2,000 = €100,000. Survivors: 47 × €2,000 = €94,000, plus coupons 47 × €160 = €7,520. Recovery: 3 × €800 = €2,400. End value = €94,000 + €7,520 + €2,400 = €103,920, a return of +3.92%.
(b) −3.0 × 0.02 = −6%, about −€5,640 on the survivors' €94,000. Combined with (a): €103,920 − €5,640 = €98,280, a mark-to-market loss of about 1.7% for the year.
Limitations: real defaults do not happen neatly at year-end, recoveries vary widely, and many high-yield bonds are hard to sell in a downturn.
Key takeaways
- High yield starts at BB+/Ba1; fallen angels and call features need special attention.
- Spreads widen before defaults peak, so prices can fall early in a downturn.
- Calculate returns under several default and recovery scenarios, not only the yield.
- High yield often falls together with stocks and is not a substitute for government bonds in a crisis.
Next step
In the next lesson you will learn how inflation-linked bonds protect against inflation and how to read the break-even inflation rate.
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