High yield bonds have increased in popularity recently because of their impressive yield and performance. Often referred to as junk bonds, high yield bonds are unique and usually share characteristics of both bonds and stocks. Although high yield bonds are categorized as fixed income, a typically conservative investment, they require special consideration before including them in your portfolio.
Understand the basics about the high yield market before deciding whether or not to invest. High yield bonds pay a higher rate of interest than investment grade corporate bonds due to the increased risk of the companies issuing these higher yielding bonds. To attract buyers for their bonds, these companies must offer a yield much higher than companies in better financial shape. High yield bond issuers have credit ratings below investment grade, which is why they are often referred to as junk. Some companies have consistently maintained junk ratings for their bond issuances. “Fallen angels” refer to those companies whose bonds previously were rated as investment grade but have now deteriorated into junk.
High yield bonds are more sensitive to credit cycles than interest rate cycles, and perform similar to equities (see the chart above). During the last ten years, high yield bonds have been highly correlated (87%) to the S&P 500, and have outperformed the S&P 500 on a total return basis. Although junk bonds performed positively in each of the last four calendar years, investors should closely monitor important factors such as high yield issuance, issuer credit quality and defaults. Bad loans are often made in good times.
Investors can access the high yield market through mutual funds, exchange traded funds and separately managed accounts. Many investors buy mutual funds and employ a manager to pick the best issues for the portfolio. Mutual funds typically have higher management fees and may be subject to asset-based sales commissions. exchange traded funds generally have lower annual expenses and low trading costs; however, there is no manager deciding which bonds to hold. Separately managed accounts hold individual bonds and investors know exactly what they own; however, investment minimums are prohibitive for most investors.
It is imperative that investors understand the costs, benefits and challenges of investing in high yield bonds. Depending on your individual goals, needs and risk tolerance, junk bonds may be a potential investment opportunity. Speak with your financial advisor about the risks and appropriateness of high yield bonds before making the decision to invest.
James Peters, CFA, CFP
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