High-yield corporate bonds and senior loans currently offer investors three significant advantages relative to equities.
First, their strong, historically above-average dividend yields. High-yield bonds currently yield around 7.7%, and senior loans 10.3%. These investments are a better buy right now than during most of the past two decades, when looking at yields at least.
Second, their significant, attractive spreads to equities. In other words, these investments are attractively priced relative to equities.
Third, they are comparatively low risk and volatility. Particularly impactful considering their above-average yields and spreads.
In my opinion, the three advantages above make high-yield corporate bonds and senior loans broadly better investments than equities, with superior risk-adjusted returns and yields. For most investors, these are the better buys. Long-term buy-and-hold investors might prefer sticking to equities, as I do expect these to outperform long-term.
Historically Above-Average Yields
Federal Reserve hikes led to sharply higher interest rates across fixed-income asset classes, with high-yield corporate bonds seeing their rates rise by 1.5%, from 6.2% to 7.7%. Senior loan rates increased by 4.2%, from 6.1% to 10.3%. As senior loans are variable rate loans, their coupon rates are more immediately sensitive to Fed rates. The market could have pushed high-yield bond rates higher in similar magnitudes though, it did not.
ETFs have also seen their yields increase.
The Invesco Senior Loan ETF (BKLN), the largest senior loan ETF and industry benchmark, trades with the highest dividend yield in its history, and by a very wide margin.
The iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the largest high-yield bond ETF and industry benchmark, trades with a historically above-average yield. In the past decade, the fund has only traded with a higher yield during a few days during the pandemic, some months in 2016.
Some smaller high-yield ETFs offer even stronger yields than HYG, including the SPDR Portfolio High Yield Bond ETF (SPHY) and the FlexShares High Yield Value-Scored Bond Index Fund ETF (HYGV).
It generally takes years for a fund’s existing bond portfolio to mature/be replaced, so it generally takes a few years for higher rates to fully impact a bond fund. These issues somewhat understate the current and expected yield of the funds above.
High-yield corporate bonds and senior loans offer investors strong, historically above-average yields. This is a significant benefit and one which might tilt the scale in their favor and against equities. It is also of particular importance to income investors and retirees. When high-yield bond ETFs yielded 4.0% – 5.0%, some retirees might have been forced into the stock market to fund their retirement. With (some) of these ETFs yielding 7.0% – 8.0%, the pressure is much lower.
Attractive Spreads
Bonds trade with comparatively attractive spreads to equities, at least compared to recent averages.
Right now, the average S&P 500 component sports an earnings yield of 1.0% lower than prevailing BBB bond rates. For most of the past 30 years, both figures have been (roughly) equal.
S&P 500 earning yields are slightly higher than 10y treasury rates right now, but spreads were much wider in the past. The last time treasuries were this attractively priced was in 2003, more than twenty years ago.
High-yield corporate bonds and senior loan ETFs also sport attractive spreads relative to equities.
Spreads between benchmark high-yield ETFs and the S&P 500 are at their widest levels in decades.
Spreads between senior loan ETFs and the S&P 500 are at their widest levels in history.
Considering the above, it seems that high-yield bonds and senior loans offer comparatively strong yields and value propositions to equities, at least relative to historical averages. This is a significant advantage for these securities and might also tilt the scales in their favor. Senior loans look much stronger as an investment with a 7.6% spread to equities, compared to a 2.0% spread.
As an aside, do remember that higher rates might not have necessarily led to higher bond/equity spreads. Higher rates might have simply led to lower equity prices, as occurred in 2022, leading to similar spreads between these securities. The fact that this did not occur is incredibly important, and notable. High-yield bonds would not look so attractively priced if the S&P 500 traded at 3000, for instance.
Lower Risk
Debt is senior to equity, which means that high-yield corporate bonds and senior loans are both generally safer, lower-risk, lower-volatility investments than equities.
Losses tend to be lower during downturns and bear markets, as was the case in early 2020.
It was also the case during 2022. Do note that higher rates do not necessarily lead to equity losses, so the S&P 500 is not destined to underperform next time rates rise. Still, the expectation should be for higher equity volatility and losses.
High-yield bonds and senior loans are safer and less volatile than equities, a significant advantage.
Lower-Risk Higher-Yield – Strong Combination
High-yield bonds and senior loans are lower-risk, higher-yield securities than equities, an incredibly strong combination.
In my opinion, said combination makes these securities stronger overall investments than equities for most retirees. Retirees can easily achieve sustainable +7.0% dividend yields without equity risk. Doing so should allow most retirees to easily fund their retirement needs without excessive risk. The S&P 500 should outperform still, as it has for decades, but that does not mean that investors can safely withdraw +7.0% from their equity portfolio. Equities are very volatile, so investors must avoid (excessive) selling during downturns to limit significant decreases in their share count.
According to Vanguard, long-term investors can only safely withdraw 3.0% – 4.0% from their investment portfolios every year. Specifics do matter, and conditions could always change moving forward.
As a final point, do note that these issues are of less importance for long-term, buy-and-hold investors. For these, equities should deliver higher long-term total returns, as they have for decades.
Conclusion
High-yield corporate bonds and senior loans currently offer investors three key advantages relative to equities: strong, above-average yields, wider spreads, and comparatively low risk and volatility. These advantages make high-yield bonds and senior loans stronger investments than equities, in my opinion at least.
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