Assessing the Safety of High-Yield Bonds
High-yield bonds are a great investment option for long-term returns, bankruptcy protection, and portfolio diversification. However, the reputation of high-yield bonds has been tarnished by the fall of "Junk Bond King" Michael Milken. High-yield bonds have a higher risk of default and volatility than investment-grade bonds. They also have more interest rate risk than stocks. In the high-risk debt category, emerging market debt and convertible bonds are the main alternatives to high-yield bonds. For the average investor, high-yield mutual funds and ETFs are the best ways to invest in junk bonds.
Despite their classification as precarious investments, high-yield bonds, commonly called junk bonds, might not warrant the persistently negative image associated with them. In reality, integrating these high-risk bonds into a portfolio could effectively mitigate overall portfolio risk when viewed through the traditional lenses of diversification and asset allocation.
It's crucial to explore the intricacies of high-yield bonds, including their inherent risks and the rationale behind incorporating them into investment strategies. Investors can access high-yield bonds through individual issuances, high-yield mutual funds, and exchange-traded funds (ETFs) specializing in junk bonds.
High-Yield Bonds: Deciphering Risk and Reward
A high-yield bond is generally characterized as a debt obligation holding a bond rating of Ba or lower by Moody's, or BB or lower according to Standard & Poor's. Often colloquially labeled as junk bonds or "below investment grade," these bonds signify a precarious financial standing for the issuing company. Lower ratings indicate a higher likelihood of missing interest payments or facing default compared to issuers of investment-grade bonds.
It's crucial to note that a sub-investment-grade classification doesn't necessarily imply mismanagement or fraudulent activities by a company. Well-established companies can encounter financial challenges due to various factors, such as a single unprofitable year or unforeseen events. Even top S&P 500 firms have experienced the downgrade of their bonds to "junk" status; a notable example is Moody's 2019 downgrade of Ford's debt.
Conversely, bonds issued by a recently established or newly public company may carry lower ratings due to the absence of an extensive financial track record. Regardless of the cause, being perceived as less creditworthy translates to higher borrowing costs for these companies. Their interest payments are elevated, akin to individuals with low credit scores facing higher APRs on credit cards. This risk prompts the classification of these bonds as high-yield, offering elevated interest rates as compensation for the additional risks involved.
Advantages of High-Yield Bonds
Due to elevated interest rates, high-yield investments consistently yield superior returns compared to investment-grade bonds. Over the long term, high-yield bonds surpass returns from CDs and government bonds. For those seeking higher yields within a fixed-income portfolio, this stands as the primary advantage of high-yield bonds: generating income.
In the event of a company's bankruptcy, debt securities enjoy a crucial advantage over equity investments. Bondholders are prioritized first during the liquidation process, followed by preferred stockholders and, lastly, common stockholders. This added layer of protection serves as a valuable shield against substantial losses, mitigating the impact of defaults.
The performance of high-yield bonds deviates from that of both investment-grade bonds and stocks. With yields surpassing those of investment-grade bonds, they exhibit reduced vulnerability to interest rate fluctuations, especially at lower credit quality levels. Operating akin to stocks relying on economic strength, the low correlation of high-yield bonds makes them an excellent tool for diminishing overall portfolio risk.
High-yield bonds serve as a counterbalance to assets sensitive to interest rate shifts or broader stock market trends. Notably, during the 2008 financial crisis, high-yield bonds collectively incurred fewer losses than stocks. Furthermore, while long-term Treasury bonds faced a decline in 2009, high-yield bonds experienced a rise in value, with high-yield bond funds generally outperforming stocks during the market rebound.
High-Yield Bonds Negative Reputation
If high-yield bonds have so many advantages, why are they commonly known as junk bonds? Unfortunately, the reputation of high-yield bonds as an asset class was damaged due to the high-profile downfall of "Junk Bond King" Michael Milken.
In the 1980s, Milken, an executive at Drexel Burnham Lambert Inc., gained notoriety for his influential role on Wall Street. He significantly expanded the utilization of high-yield debt in mergers and acquisitions (M&A), fueling the leveraged buyout boom. Milken made his fortune trading bonds issued by fallen angels, which are companies that were once financially stable but experienced difficulties that led to credit rating downgrades.
In 1989, Rudolph Giuliani brought 98 counts of racketeering and fraud against Milken under the RICO Act. Following a plea bargain, he served 22 months in prison and paid over $600 million in fines and civil settlements. Presently, the persisting negative perception of junk bonds is often attributed to the questionable practices of Milken and similarly high-flying financiers on Wall Street.
Assessing Risks in High-Yield Bonds
Among the drawbacks of high-yield investments, increased volatility and default risks top the concerns. In 2017, U.S. high-yield bond defaults stood at 1.8%, per Fitch Ratings. However, the global surge in corporate indebtedness raises alarms among analysts and economists. The U.S. witnessed a 14% default rate in high-yield bonds during the 2009 recession, and a similar trend is anticipated in the next downturn.
It's crucial to note that managers of high-yield mutual funds can manipulate default rates. They can swap bonds before defaults, replacing them with new ones. To gauge a fund's default risk more accurately, examine its historical total return during downturns. A turnover exceeding 200% may indicate frequent replacement of near-default bonds. Additionally, assessing the fund's average credit quality, particularly if it hovers at BB or B on the Standard & Poor's scale, provides insight. A CCC or CC average signals high speculation, with D indicating default.
Interest Rate Risk
Another peril in high-yield investing is the impact of a weak economy and rising interest rates on yields. The inverse relationship between bond prices and interest rates, familiar to bond investors, is accentuated in the high-yield sector. Although less sensitive to short-term rates, junk bonds closely track long-term interest rates. The Federal Reserve's interest rate hikes in 2017 and 2018 initially led to bond price declines. However, a subsequent reversal in 2019 resulted in market gains.
During a bullish market, high-yield investments may underperform compared to equities. Fund managers might respond by turning over portfolios, increasing turnover percentages, and incurring additional expenses for investors. While a healthy economy is perceived as a safeguard for high-yield bonds, investors should remain vigilant regarding other risks, including weakening foreign economies, currency rate fluctuations, and diverse political uncertainties.
Emerging Market Debt
For investors seeking substantial yield premiums beyond domestic junk bonds, alternative opportunities abound. Emerging market debt securities emerge as a promising addition to portfolios, offering cost-effectiveness compared to their U.S. counterparts due to smaller individual domestic markets. Collectively, these securities constitute a noteworthy segment of the global high-yield market.
Some fund managers strategically incorporate convertible bonds from companies whose stock prices have sharply declined, rendering the conversion option nearly worthless. Termed "busted convertibles," these investments are acquired at a discount, mirroring the steep fall in the market price of associated common stock.
Fund managers often wield the flexibility to diversify further by incorporating various assets. High-dividend-yield common stocks and preferred shares, akin to high-yield bonds, contribute substantial income. Speculative characteristics akin to junk bonds are found in certain warrants. Additionally, leveraged bank loans, featuring a higher interest rate reflecting elevated borrower risk, present another viable alternative.
For the typical investor, high-yield mutual funds and ETFs present optimal avenues for venturing into junk bonds. These investment vehicles aggregate a spectrum of lower-rated debt obligations, mitigating the inherent risks associated with financially distressed companies.
Before engaging in high-yield bonds or other securities of a similar nature, a comprehensive understanding of associated risks is paramount. Following diligent research, inclusion in your portfolio may be warranted if deemed suitable for your financial situation. The allure of heightened income potential and a reduction in overall portfolio volatility are compelling reasons to contemplate high-yield investments.