By Philip van Doorn
Improved credit quality, expectations for a mild recession or soft economic landing and current valuation discounts all bode well for high-yield bonds
High-yield bonds are also known as junk bonds — they are riskier than investment-grade bonds and pay much higher interest rates. But the current set of circumstances might lead to excellent performance over the next few years for investors who focus on the space right now.
Below are comments from Paul Dlugosch and Jeff Deardorff, who co-manage the Buffalo High Yield Fund along with Jeff Sitzmann, as well as thoughts about the direction of the bond market, interest rates and the economy from Garrick Bauer and Nick Sargen of Fort Washington Asset Management of Cincinnati.
High-yield bonds are expected to have higher risk of default — the failure of a borrower to pay interest or principal. The primary reason to invest in bonds is to receive income, but there can also be some capital gains if you purchase them at discounts to face value, or if interest rates decline after you buy them.
Investment-grade bonds are those rated BBB- or higher by Standard & Poor’s and Fitch, and Baa3 or higher by Moody’s. Fidelity breaks down the credit agencies’ ratings hierarchy.
Your first question now might be why you might consider buying high-yield bonds, or shares of a junk-bond fund now, when short-term interest rates are so high that you can get a yield of 5% on a 12-month certificate of deposit at a bank.
There are several answers:
A high-yield bond fund
The Buffalo High Yield Fund has an SEC 30-day yield of 7.67%. The 30-day yield is an estimate meant to be used when making comparisons among mutual funds. The fund pays monthly dividends.
The fund’s Institutional shares have annual expenses of 0.87% of assets, while its Investor share class has an expense ratio of 1.02%. Both funds are rated five stars (the highest rating) within Morningstar’s “High Yield Bond” fund category.
Since bond prices move in the opposite direction of interest rates, it might useful to see how much the share price has fluctuated. The Buffalo High Yield Fund’s Institutional shares were made available in 2019. So here is a 20-year price chart through April 25 — with dividends excluded — for the Investor shares:
Over the past 20 years, disruptions affecting the share price have included the 2008-2009 credit crisis, the early stages of the COVID-19 pandemic in 2020, the upward swing in prices as the Federal Reserve lowered short-term rates near to zero and then the price reversal that began when the Fed raised rates to fight inflation last year. The share price has also reflected any losses the fund took when bonds defaulted, or other losses if the managers decided to sell bonds at discounts as default risk increased.
But the share price is pretty much where it was 20 years ago, despite the fund’s expenses. Meanwhile, it has paid high dividends the entire time. The fund’s 30-day yield of 7.67% compares to a yield of 4.28% for the Bloomberg U.S. Aggregate Bond Index, which represents most domestically issued investment-grade bonds.
Here’s a comparison of average annual returns (with dividends reinvested) for various periods between the fund’s Investor share class, its benchmark, the ICE BofA High Yield Index and the Bloomberg U.S. Aggregate Bond Index:
Fund or index Average return -- 3 Years Average return -- 5 Years Average return -- 10 Years Average return -- 15 Years Average return -- 20 Years
Buffalo High Yield Fund -- Investor share class 7.68% 4.44% 4.09% 5.73% 5.81%
ICE BofA U.S. High Yield Index 5.05% 3.12% 3.96% 6.21% 6.73%
Bloomberg U.S. Aggregate Bond Index -3.06% 1.33% 1.37% 2.84% 3.20%
Source: FactSet
The Buffalo High Yield Fund has outperformed its benchmark for 3, 5 and 10 years, while underperforming it for the 15 and 20-year periods. Then again, the index doesn’t have expenses affecting its return. Meanwhile, the fund has handily beaten the Bloomberg U.S. Aggregate Bond Index, despite taking more credit risk.
The fund had $309 million in assets as of march 31. It held 137 investments, with issuers and borrowers across industries, although the energy industry had…