Many high-risk bonds are not junk
Reviewed by JeFreda R. Brown
Although they are considered risky investments, high-yield bonds—commonly known as junk bonds—may not deserve the negative reputation that still clings to them. In fact, the addition of these high-risk bonds to a portfolio can actually reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation.
Let’s look more closely at what high-yield bonds are, what makes them risky, and why you may want to incorporate them into your investing strategy. High-yield bonds are available to investors as individual issues, through high-yield mutual funds, and as junk bond exchange-traded funds (ETFs).
Key Takeaways
- High-yield bonds offer higher long-term returns than investment-grade bonds, better bankruptcy protections than stocks, and portfolio diversification benefits.
- High-yield bonds face higher default rates and more volatility than investment-grade bonds, and they have more interest rate risk than stocks.
- Unfortunately, the high-profile fall of “Junk Bond King” Michael Milken damaged the reputation of high-yield bonds as an asset class.
- Emerging market debt and convertible bonds are the main alternatives to high-yield bonds in the high-risk debt category.
- For the average investor, high-yield mutual funds and ETFs are the best ways to invest in junk bonds.
Understanding High-Yield Bonds
Generally, a high-yield bond is defined as a debt obligation with a bond rating of Ba1 or lower according to Moody’s or BB+ or lower on the Standard & Poor’s scale.
In addition to being popularly known as junk bonds, they are also referred to as “below investment grade.” Low ratings mean that the company’s financial situation is shaky. So, the possibility that the firm could miss making interest payments or default is higher than that of investment-grade bond issuers.
A bond classification below investment grade does not necessarily mean that a company is mismanaged or engaged in fraud. Many fundamentally sound firms run into financial difficulties at various stages. One poor year for profits or a tragic chain of events can cause a company’s debt obligations to be downgraded.
The opposite can also happen. The bonds issued by a young or newly public company may be low-rated because the firm does not yet have a long track record or financial results to evaluate.
Whatever the reason, being considered less creditworthy means borrowing money is more expensive for these companies. They have to pay more interest on their debt, the same way individuals with low credit scores often pay a higher APR on their credit cards. Therefore, they are called high-yield bonds. They offer higher interest rates because of the additional risks.
Benefits of High-Yield Bonds
Higher Returns
As a result of the increased interest rates, high-yield investments have generally produced better returns than investment-grade bonds. High-yield bonds also have higher returns than CDs and government bonds in the long run. If you are looking to get a higher yield within your fixed-income portfolio, keep that in mind. The number one advantage of high-yield bonds is income.
Bankruptcy Protections
Many investors are unaware of the fact that debt securities have an advantage over equity investments if a company goes bankrupt. Should this happen, bondholders would be paid first during the liquidation process, followed by preferred stockholders, and lastly, common stockholders.
This added safety can prove valuable in protecting your portfolio from significant losses and reducing the damage from defaults.
Diversification
The performance of high-yield bonds does not correlate exactly with either investment-grade bonds or stocks. Because their yields are higher than investment-grade bonds, they’re less vulnerable to interest rate shifts.
This is especially true at lower levels of credit quality, and high-yield bonds are similar to stocks in relying on the strength of the economy. Because of this low correlation, adding high-yield bonds to your portfolio can be an excellent way to reduce overall portfolio risk.
High-yield bonds can act as a counterweight to assets that are more sensitive to interest rate movements or overall stock market trends. For example, high-yield bonds as a group lost far less than stocks during the financial crisis in 2008. When the S&P 500 dropped 37% in 2008, the average high-yield bond lost 26%.
The Bad Reputation of High-Yield Bonds
If they have so many pluses, why are high-yield bonds derided as junk? Unfortunately, the high-profile fall of “Junk Bond King” Michael Milken damaged the reputation of high-yield bonds as an asset class.
During the 1980s, Michael Milken—then an executive at investment bank Drexel Burnham Lambert Inc.—gained notoriety for his work on Wall Street. He greatly expanded the use of high-yield debt in mergers and acquisitions (M&A), which in turn fueled the leveraged buyout boom.
Milken made millions of dollars for himself and his Wall Street firm by specializing in bonds issued by fallen angels. Fallen angels are once-sound companies that experienced financial difficulties that caused their credit ratings to fall.
In 1989, Rudolph Giuliani charged Milken under the RICO Act with 98 counts of racketeering and fraud. After a plea bargain, he served 22 months in prison and paid over $600 million in fines and civil settlements.
Today, many on Wall Street will attest that the negative perception of junk bonds persists because of the questionable practices of Milken and other high-flying financiers like him.
Risks of High-Yield Bonds
Default Risk
High-yield investments also have their disadvantages, and investors must consider higher volatility and the risk of default at the top of the list.
However, the rising level of corporate indebtedness around the world troubles many analysts and economists. High-yield default rates in the U.S. reached over 14% during the last recession in 2009, and they are very likely to rise again during the next downturn.
You should be aware that default rates for high-yield mutual funds are easily manipulated by managers. They have the flexibility to dump bonds before defaults and replace them with new bonds.
How can you more accurately estimate the default rate of a high-yield fund? You could look at what has happened to the fund’s total return during past downturns. If the fund’s turnover is extremely high (over 200%), this may be an indication that near-default bonds are being replaced frequently.
You could also look at the fund’s average credit quality as an indicator. This can show you if the majority of the bonds being held are just below investment-grade quality at BB or B on the Standard & Poor’s scale. If the average is CCC or CC, then the fund is highly speculative.
Important
High-yield bonds tend to have shorter maturities than investment-grade bonds, which can reduce their sensitivity to interest rate changes.
Interest Rate Risk
Another pitfall of high-yield investing is that a weak economy and rising interest rates can worsen yields. If you’ve ever invested in bonds in the past, you’re probably familiar with the inverse relationship between bond prices and interest rates.
As interest rates go up, bond prices will go down. Though they are less sensitive to short-term rates, junk bonds closely follow long-term interest rates.
During a bull market run, you might find that high-yield investments produce inferior returns when compared to equity investments. Fund managers may react to this slow bond market by turning over their portfolios. That will lead to higher turnover percentages and additional fund expenses that are ultimately paid by you, the end investor.
In times when the economy is healthy, many managers believe that it would take a recession to plunge high-yield bonds into disarray. However, investors must still consider other risks, such as the weakening of foreign economies, changes in currency rates, and various political risks.
Alternatives to High-Yield Bonds
Emerging Market Debt
If you’re looking for some significant yield premiums, domestic junk bonds aren’t the only asset in the financial sea. Emerging market debt securities may be a beneficial addition to your portfolio.
Typically, these securities are cheaper than their U.S. counterparts in part because they have much smaller domestic markets individually. As a group, they account for a significant portion of global high-yield markets.
Convertible Bonds
Some fund managers like to include convertible bonds of companies whose stock price has declined so much that the conversion option is practically worthless.
These investments are commonly known as busted convertibles and are purchased at a discount since the market price of the common stock associated with the convertible has fallen sharply.
Other Alternatives
Many fund managers are given the flexibility to include certain other assets to help diversify their investments even further. High-dividend-yield common stocks and preferred shares are comparable to high-yield bonds because they generate substantial income.
Certain warrants also have some of the speculative characteristics of junk bonds. Another possibility is leveraged bank loans. These are essentially loans that have a higher rate of interest to reflect the higher risk posed by the borrower.
Are High-Yield Bonds a Good Investment?
High-yield bonds can be a good investment because they come with higher returns than traditional bonds but come with greater risk. As high-yield bonds are issued by companies with lower credit ratings, they have a higher chance of default. As such, they’re better suited for investors with higher risk tolerances and diversified portfolios.
What Classifies a Bond as High Yield?
A bond is classified as high yield when it has a low credit rating as determined by the three main credit rating agencies: S&P, Moody’s, and Fitch. When a bond is rated BB+ and below by S&P or Fitch and Ba1 or below by Moody’s, it is considered high-yield. High-yield bonds have a higher chance of default, making them riskier investments for investors. Due to carrying higher risk, they also come with higher returns.
What Happens to High-Yield Bonds in a Recession?
In a recession, the prices of high-yield bonds tend to drop and their yields tend to increase. This is so because risk-averse investors shift to safer assets when the economy is doing poorly, which lowers the demand for riskier assets, such as high-yield bonds. The lower demand results in a drop in prices and an increase in yields to attract investors.
The Bottom Line
For the average investor, high-yield mutual funds and ETFs are the best ways to invest in junk bonds. These funds offer a pool of low-rated debt obligations, and the diversification reduces the risk of investing in financially struggling companies.
Before you invest in high-yield bonds or other high-yield securities, you should be aware of the risks involved. After doing your research, you may want to add them to your portfolio if you feel these investments suit your situation. The potential to provide higher income and reduce overall portfolio volatility are both good reasons to consider high-yield investments.