Michael Hong
Michael Hong
High-yield bonds can survive, thrive—and also dive—as an altogether separate species from investment-grade bonds. Vanguard believes that high-yield bonds can play a complementary role in an already diversified portfolio. But investors should be aware of their inherent volatility.

“The high-yield bond market has an asymmetric risk profile. Investors can lose a significant portion of their investment if an issuer defaults,” said Wellington Management Company’s Michael Hong, the portfolio manager for Vanguard High-Yield Corporate Fund since 2008. “In our experience, the market often underestimates the probability of a negative outcome.”

Vanguard High-Yield Corporate Fund is managed differently from most of its industry peers. Whereas many funds invest in the highest-yielding, lower-quality segment of the market, Mr. Hong and his team focus on high-yield bonds with higher credit-quality ratings. “We believe that over time, this part of the market offers the best risk/reward profile,” Mr. Hong said.

Albatross and opportunity

Although high-yield bonds and bond funds can play an important role in an investment portfolio, they generally don’t provide the same cushion as U.S. Treasury securities or investment-grade corporate bonds. This point was underscored in late 2015, when the high-yield market experienced disruption and sharp declines.

Much of the weakness was related to the drop in oil prices. Their decline punished energy-sector companies, which represent about 10% of the high-yield bond market—down from 15% in 2014, according to Mr. Hong.

The High-Yield Corporate Fund has been cautious about the energy sector. Mr. Hong said he favored issuers with strong balance sheets and lower production costs “that we believe would be long-term survivors.”

“Lower oil prices also create opportunities,” Mr. Hong said. “In the current market, for example, we have found compelling opportunities in the technology, cable, and health care industries that have more exposure to U.S. domestic growth. Some of these issuers are offering robust yields as a result of the general market weakness, but they continue to have stable or improving credit fundamentals.”

Similarities and differences

Investors may hear that high-yield bonds behave more like stocks than bonds, but there are major differences.

“High-yield bonds are risk assets,” Mr. Hong said. “Therefore, they often move more like stocks than bonds in the sense that they are more sensitive to credit conditions than to interest rate changes. However, they have a higher claim on the assets of a company in a default or restructuring. This means that, unlike stocks, high-yield bonds can often provide protection in sharply negative markets.

“In addition, high-yield bonds generate income for investors. They pay coupons that are high relative to the dividends paid by stocks, and historically, they’ve offered attractive returns with less volatility.

“Finally, high-yield bonds are still fixed income instruments, and investors will get paid back at par when a bond matures unless there is a credit impairment. This gives managers the opportunity to improve returns for investors by avoiding issuers that may default, and it highlights why we focus on the higher-quality portion of the high-yield market and emphasize fundamental credit research in this fund.”

All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future results. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.