PIMCO believes that high yield bonds-those rated below ‘BBB-’ by Standard & Poor’s and below ‘Baa3’ by Moody’s—can play an important role in many portfolios.

High yield bonds typically offer higher interest rates than Treasuries or high-grade corporates and hold the potential for capital appreciation in the event of a rating upgrade, an economic upturn or improved performance at the issuing company. The high yield sector also generally has a low correlation to other sectors of the fixed income market, which can improve the diversification of a broad allocation to fixed income.

Many companies that are capital-intensive or refinancing debt turn to the high yield market to finance their capital needs or consolidate and pay down bank lines of credit. In the 1980s, many high yield bonds were used to finance speculative acquisitions, mergers or leveraged buyouts, and some are still used for this purpose.

Corporate issuers of high yield bonds also include both "fallen angels," which are former investment-grade companies whose debt has been downgraded, and "rising stars," which are emerging or start-up companies. Debt ratings of the fallen angels can sometimes be upgraded to investment-grade status if their prospects improve while rising stars can see their ratings upgraded once they achieve the necessary size, capital strength, or operating history.

Enhanced current income. For much of the 1980s and 1990s, high yield bonds typically offered about 300 to 400 basis points of additional yield relative to Treasury securities of comparable maturity, according to The Bond Market Association. According to Merrill Lynch, high yield bonds offered about 306 basis points of additional yield relative to Treasuries as of Sept. 30, 2005.

• Capital appreciation. An economic upturn or improved performance at the issuing company can have a significant impact on the price of a high yield bond. This capital appreciation is an important component of PIMCO’s total return approach to bond investing. Positive events that can push up the price of a bond can include ratings upgrades, improved earnings reports, mergers or acquisitions, management changes, positive product developments or market-related events. On the other hand, negative credit events or an economic downturn may have a negative effect on the price of high yield bonds. Like equities, high yield bond prices are much more sensitive to the economic outlook and corporate earnings than to day-to-day fluctuations in interest rates. In a rising-rate environment, as would be expected in the recovery phase of the economic cycle, high yield bonds would be expected to outperform many other fixed income classes. Although both equities and high yield bonds tend to rise in value during a recovery, returns on high yield bonds tend to be less volatile because the income component of the return is larger, providing an added measure of stability. Also, bondholders usually have priority over stockholders in a company’s capital structure in the event of bankruptcy or liquidation. This means that an investor considering a company-or group of companies-that has a below-investment-grade rating will face less default risk investing in that company’s bonds than purchasing the company’s stock.
  
  
• Relatively low duration. Low duration, or sensitivity to changes in interest rates, tends to lower volatility. High yield bonds are typically issued with terms of 10 years or less and are callable after four or five years. Higher-rated borrowers such as the U.S. Treasury and investment grade corporations are able to issue securities with longer maturities (and longer durations).
  
  
• Diversification benefits. High yield bonds are considered a separate asset class and offer different risk and reward characteristics. High yield bonds typically have a low correlation to other fixed income sectors, which means that adding high yield securities to a broad fixed income portfolio may enhance portfolio diversification. Diversification does not ensure against loss but it can decrease risk and improve the consistency of portfolio returns.

Investors can mitigate the risks in high yield bonds by diversifying their holdings across issuers and across industries and by carefully monitoring the financial health of the companies they invest in.