When the global economy is riding high and credit problems are low, they are called ‘high yield bonds’ but when we hit a rough patch and defaults are on the rise, they are referred to simply as ‘junk bonds’.

The class of lower grade, higher yielding fixed income seems to come in and out of favour at various times during each economic cycle. Yet, this often overlooked asset class has increasingly found a place in many widely accepted investment strategies and the timing now looks about right for adding positions.

When considering this category, investors should understand the sector encompasses a wide swath of individual securities. For starters, the standard definition of ‘high yield’ refers to any bond rated below investment grade, defined as ‘BBB’, by either of the two main credit rating agencies: Moody’s and Standard & Poor’s. In general, credit ratings begin at ‘AAA’ for the most highest quality, most secure bonds and, similar to a high school report card, fall all the way down to ‘D’, which means the security is in default. Thus, a security lumped into the ‘high yield’ bucket might be hovering just under investment grade at BB+, or teetering on the brink of insolvency at CCC-.

While most high yield bonds are still current on interest payments, the lower a bond’s rating, the higher the probability of a default somewhere down the line. Therefore, in order to compensate for the higher risk, these bonds must pay higher rates of interest in order to attract potential investors.

The timing may now be about right to start a position in high yield in light of today’s lower prices and higher rates of interest being offered. The metrics on this asset class are especially attractive when compared to the steadily declining yields on the highest quality bonds.

The BofA Merrill Lynch US High Yield Master index, somewhat of an industry standard, is presently yielding 7.6 per cent, or about 6.5 per cent more than the benchmark ten-year US Treasury yield which has fallen to just over two per cent at present.

By comparison, in June of last year the BofA HY index reached a low yield of 4.84 per cent while the Treasury bond yielded 2.5 per cent, giving high yield investors an edge of just 2.34 per cent. The difference or ‘spread’ between Treasuries and corporate debt is a key metric in evaluating the attractiveness of this category.

Interestingly, the trough in high yield spreads last year coincided almost perfectly with the peak in oil prices several months ago. Since oil prices began plunging late last year, investors have fled the high yield sector on concerns that falling commodities prices would imperil many overleveraged energy concerns. Indeed, energy-related defaults have risen this year and now total 12 for the first half of 2015 according to Moody’s. The current number of defaults amounts to three per cent of the Barclays High Yield Energy Index.

Investors appear to be well compensated, however. By some calculations, current bond prices imply an overall default rate of around 15 per cent which is probably too high now that energy prices have begun to stabilise. Moreover, the rise in defaults is occurring mainly within the energy sub-sector. The total percentage of bonds currently running into trouble is just 2.3 per cent according to a recent Moody’s report.

High yield has clearly become more enticing in a world where income returns are harder to come by. Right now, the high yield spread is the widest since 2013 during the ‘taper tantrum’ sell off. Prior to that, we also saw spreads widen dramatically in 2011 during the European debt crisis. Buyers during both those times of uncertainty were ultimately rewarded.

Because individual security risk is high, most investments in this asset class are made through a mutual fund approach with bets effectively spread across a large number of issues. This strategy reduces portfolio risk by ensuring that the credit hits as a percentage of the total portfolio are minimised. Investors expect the higher yields to more than make up for credit defaults.

Note that even when companies end up in the bankruptcy court, final pay-off values are usually worked out to some portion of their original face amount. Bonds are typically higher in the pecking order in terms of claims on assets and bond holders usually get something, whereas equity holders are often wiped out in a worst-case scenario.

Actively managed funds are quite popular in the sector as a strong team of credit analysts can add value by evaluating the risk/return proposition of each holding. The ultimate goal of a fund manager is to find the diamonds in the rough where the underlying fundamentals are stable but where some investors may be overreacting to bad news or selling just because of a poor rating.

As I mentioned here in last month’s article, “The ETF Revolution”, exchange-traded funds are gaining popularity for all classes of assets. High yield has not been an exception and ETFs for the category have seen significant growth since the first one was created in 2007. ETF’s now comprise more than $30 billion of assets in the space according to Morningstar.

Whether through an ETF or a seasoned mutual fund, high yield deserves a good look at these levels. I would recommend, however, staying away from those funds dabbling in the very lowest quality credits. There may be a difference between high yield and junk, after all.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.