As an asset class, bonds are usually recommended to investors who are risk averse (as compared to investors in equities who have a higher risk appetite). Generally, such risk averse investors are under the impression that bond returns are inverse to stock returns. So says conventional wisdom, or so it is thought.
But, hold on. A look at price charts such as Figure 1 is enough to suggest otherwise. Now that would be unsettling to any mom-and-dad fixed income investor who thought their pensions are safely invested in bonds.
High Yield Junk Bonds command higher risk premiums over the central bank cash rate because they are issued by high credit risk entities. In a scenario where the economy is doing well, these high credit risk issuers have healthier balance sheets and cash flows, and report better earnings; accordingly, these entities’ propensity and capacity to satisfy their debt obligations improve, and this reduces the risk premiums demanded by the market on their high yield issues, which translates into an uptrend for the bond prices. In an upbeat economic environment, stock prices are on an uptrend as well (no surprises there).
Conversely, in a scenario where the economy is in contraction, the risk premiums on the high yield junk bonds increase and this translates into a downtrend for the bond prices. (What an economic contraction does to stock prices needs no explanation.)
Investment Grade Bonds command lower risk premiums because of the excellent credit risk profile of their issuers (BBB- or higher, or Baa3 or higher, depending on the rating agency). In a rising (high) interest rate environment of high economic growth and strong equities performance, this necessarily translates into generally lower bond prices for these high quality issues. The reverse is true in a declining (low) interest rate environment of weak economic growth and a weak equities market: these high quality issues generally experience a price uptrend. (Another way of understanding this is in the context of risk substitution: dumping bonds for equities when risk appetite improves; dumping equities for bonds when risk appetite is reduced.)
Bonds generally experience lower price volatility compared to equities, and so present less of a bumpy ride for investors. But in terms of price correlation with equities – High Yield and Investment Grade: which one’s yours?
Note: Always seek the investment advice of your licensed and accredited financial advisor.