In our writings, we have often posed high yield bonds as an equity alternative.  Over the last couple decades, these two asset classes have had similar return profiles.¹

However, as we have often noted, high yield bonds have historically had less volatility/less risk relative to equities, leading to the high yield bond market’s historical risk adjusted outperformance (return/risk) versus equities (as measured by the S&P 500).

The lower risk profile for high yield bonds makes sense.  In a company’s capital structure, debt securities rank ahead of equity securities, so if a company were to run into trouble and can’t pay all of their obligations and/or the valuation of the company dramatically declines, the debt securities are paid back first and are the first to capture any remaining value in the company before anything is allocated to the equity (preferred and common) holders.

Another important fact to keep in mind about equity versus debt investing is the nature of the income they generate.  Coupon interest payments made by debt securities are contractual obligations—companies are required to make these payments in full to bond/loan holders, while dividend payments, when made on common stocks, are voluntary.  These payments are made at the discretion of the company’s Board of Directors, and can be cut back or entirely eliminated at any point.

This week we saw a clear example of why where you invest in a company’s capital structure is so important.  One of the companies we follow reported weaker than expected revenue and a need to spend money to invest in their sales force.  In order to conserve cash for this extra spending, they reduced their distribution/dividend on the equity by 50%.  In the day following the news, we saw the stock decline about 45% while the high yield bonds were down about 2%.  This company is an MLP (master limited partnership) and while not related to energy, we have seen these sorts of dividend cuts in numerous energy related MLPs over the past couple years.  While a sales miss is a negative for us, as bondholders, we ultimately see it to our benefit that the company is conserving cash and retaining it to invest in the business versus leaking it as dividends to the equity ranked below us in the capital structure.  The bonds were largely able to retain their value, while equity prices took a big hit as those equity investors that were depending on the income this security generated saw that income cut in half.

High yield bonds can generate steady coupon income over the life of the security and rank ahead of the company’s equity allowing for lower volatility.  We believe the high yield debt markets offer investors an attractive investment opportunity relative to equities.

1 Credit Suisse High Yield Index data from Credit Suisse. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market, data sourced from Credit Suisse. S&P 500 numbers based on total returns, data sourced from Bloomberg. Period covered is 9/30/91 to 9/30/16. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation. Although information and analysis contained herein has been obtained from sources Peritus 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 other fixed income securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.