Although they are considered high-risk investments, high-yield bonds—often called junk bonds—may not be worth the negative reputation that still clings to them. In fact, when considered within the classic framework of diversification and asset allocation, adding these high-risk bonds to the portfolio can actually reduce the overall portfolio risk.
Let’s take a closer look at what high-yield bonds are, what makes them risky, and why you might want to incorporate them into your investment strategy. High-yield bonds can be offered to investors as individual issuances, high-yield mutual funds, and junk bond exchange-traded funds (ETFs).
- High-yield bonds provide higher long-term returns than investment-grade bonds, better bankruptcy protection than stocks, and the benefits of portfolio diversification.
- Unfortunately, the high-profile downfall of “junk bond king” Michael Milken has damaged the reputation of high-yield bonds as an asset class.
- High-yield bonds face higher default rates and greater volatility than investment-grade bonds, and have greater interest rate risk than stocks.
- Emerging market bonds and convertible bonds are the main alternatives to high-yield bonds in the high-risk debt category.
- For ordinary investors, high-yield mutual funds and ETFs are the best way to invest in junk bonds.
Understanding high-yield bonds
Generally, high-yield bonds are defined as debt obligations that are rated Ba or lower based on bonds rated BB or lower by Moody’s or Standard & Poor’s.In addition to the so-called junk bonds, they are also called “below investment grade.” A low rating means that the company’s financial situation is unstable. Therefore, the company is more likely to fail to pay interest or default than investment-grade bond issuers.
A bond classification below investment grade does not necessarily mean that the company is poorly managed or fraudulent. Many companies with sound fundamentals have encountered financial difficulties at different stages. A year of poor profits or a series of tragic events may lead to a downgrade of the company’s debt obligations. Some of the top companies in the Standard & Poor’s 500 Index have suffered insults because their bond ratings were downgraded to “junk” status. For example, in 2019, Moody’s downgraded the debt rating issued by the automotive giant Ford to below investment grade.of
The opposite can happen. A bond issued by a young or newly listed company may have a lower rating because the company does not have a long-term track record or financial performance to evaluate.
Regardless of the reason, it is believed that lower creditworthiness means that these companies are more expensive to borrow money. They must pay more interest on their debts, just as people with low credit scores usually pay higher APRs on their credit cards. Therefore, they are called high-yield bonds. They offer higher interest rates due to the additional risk. of
Advantages of high-yield bonds
Due to rising interest rates, high-yield investments generally produce better returns than investment-grade bonds. In the long run, the returns of high-yield bonds are also higher than certificates of deposit and government bonds. If you want higher returns in your fixed income portfolio, please keep this in mind. The number one advantage of high-yield bonds is yield.
Many investors are unaware of the fact that if the company goes bankrupt, debt securities have an advantage over equity investment. If this happens, the bondholders will be paid first, then preferred shareholders, and finally common shareholders during the liquidation process. This increased security can prove valuable in protecting your investment portfolio from major losses and reducing losses caused by defaults.of
The performance of high-yield bonds is not entirely related to investment-grade bonds or stocks. Because their yields are higher than investment-grade bonds, they are less susceptible to changes in interest rates. This is especially true in the case of low credit quality, where high-yield bonds are similar to stocks in terms of reliance on economic strength. Because of this low correlation, adding high-yield bonds to your portfolio may be an excellent way to reduce overall portfolio risk.
High-yield bonds can be used as a counterweight to assets that are more sensitive to changes in interest rates or overall stock market trends. For example, during the 2008 financial crisis, high-yield bonds as a whole fell far less than stocks. As long-term Treasury bonds fell in 2009, high-yield bond prices also rose, and high-yield bond funds generally outperformed stocks during the market rebound.
The bad reputation of high-yield bonds
If they have so many advantages, why are high-yield bonds derided as rubbish? Unfortunately, the high-profile downfall of “junk bond king” Michael Milken has damaged the reputation of high-yield bonds as an asset class.
In the 1980s, Michael Milken-then an executive at the investment bank Drexel Burnham Lambert Inc.-became notorious for his work on Wall Street. He greatly expanded the use of high-yield bonds in mergers and acquisitions (M&A), which in turn promoted the leveraged buyout boom. Milken specializes in bonds issued by fallen angels, earning millions of dollars for himself and his Wall Street company. Fallen Angel is a once-sound company, but experienced financial difficulties, which led to a decline in its credit rating.
In 1989, Rudolph Giuliani charged Milken with 98 counts of racketeering and fraud under the RICO Act. After a plea bargain, he served 22 months in prison and paid more than $600 million in fines and civil settlement fees.of
Today, many on Wall Street will prove that negative views of junk bonds still exist due to the suspicious practices of Milken and other high-flying financiers like him.
The risks of high-yield bonds
High-yield investment also has its disadvantages. Investors must prioritize higher volatility and default risk. According to Fitch Ratings, the default rate of US high-yield bonds fell to 1.8% in 2017. However, the rising level of global corporate debt has troubled many analysts and economists. During the last recession in 2009, the default rate of high-yield bonds in the United States reached 14%, and it is likely to rise again during the next recession.
You should know that the default rate of high-yield mutual funds can easily be manipulated by managers. They have the flexibility to sell bonds before defaulting and replace them with new bonds.
How to more accurately estimate the default rate of high-yield funds? You can see how the total return of the fund has changed in the past downturn. If the fund’s turnover rate is extremely high (over 200%), this may indicate that bonds that are near default are being replaced frequently. You can also consider the average credit quality of the fund as an indicator. This can tell you whether most of the bonds you hold are slightly lower than the investment grade quality of BB or B in the Standard & Poor’s rating. If the average is CCC or CC, then the fund is highly speculative because D indicates default.
You should know that the default rate of high-yield mutual funds can easily be manipulated by managers.
Interest Rate Risk
Another trap of high-yield investment is that economic weakness and rising interest rates will worsen yields. If you have invested in bonds in the past, you may be familiar with the inverse relationship between bond prices and interest rates. As interest rates rise, bond prices will fall. Although they are less sensitive to short-term interest rates, junk bonds closely follow long-term interest rates. After a long period of stability, investors’ principal investment was not affected. The Fed raised interest rates several times in 2017 and 2018, but in 2019 the Fed reversed its rate cuts, driving the entire bond market to rise.of
During a bull market, you may find that high-yield investments produce poor returns compared to stock investments. Fund managers may respond to this slow bond market by switching investment portfolios. This will result in a higher turnover rate and increase the additional fund fees that will ultimately be paid by you (the ultimate investor).
In times of economic health, many managers believe that a recession is needed to bring high-yield bonds into chaos. However, investors still need to consider other risks, such as weak foreign economies, exchange rate changes, and various political risks.
Alternatives to high-yield bonds
Emerging market debt
If you are looking for some significant yield premium, domestic junk bonds are not the only asset in the financial ocean. Emerging market debt securities may be a useful addition to your investment portfolio. Generally, these securities are cheaper than similar securities in the United States, partly because their respective domestic markets are much smaller. As a group, they account for a large part of the global high-yield market.
Some fund managers like to include the convertible bonds of companies whose stock prices have fallen so much that the conversion options are effectively worthless. These investments are often referred to as bankrupt convertible bonds, and because the market price of common stocks related to convertible bonds has fallen sharply, they are purchased at a discount.
Many fund managers have the flexibility to incorporate certain other assets to help further diversify their investments. High-dividend common stocks and preferred stocks are comparable to high-yield bonds because they generate considerable income. Certain warrants also have some speculative characteristics of junk bonds. Another possibility is leveraged bank loans. These loans are essentially loans with higher interest rates to reflect the higher risks posed by borrowers.
For ordinary investors, high-yield mutual funds and ETFs are the best way to invest in junk bonds. These funds provide a range of low-rated debt, and diversification reduces the risk of investing in financially troubled companies.
Before investing in high-yield bonds or other high-yield securities, you should understand the risks involved. After completing the research, if you think these investments are suitable for your situation, you may want to add them to your portfolio. The potential for higher income and lower overall portfolio volatility are all good reasons to consider high-yield investments.