High-yield bonds: Weighing the risks
Key Points
- What's the Attraction?
- The Risk Trade-Off
- The Search for Growth
- Look Before You Leap Into High Yields
- A Guide to High-Yield Bond Ratings
- Points to Remember
Although some call them "junk" bonds, high-yield bonds have been popular on Wall Street, and billions of dollars' worth are traded annually.
As the label "high-yield" suggests, the competitive yields of these issues have helped attract assets. With yields significantly higher than elsewhere in the bond market, many investors have turned to high-yield bonds for both performance and diversification against stock market risks.
These are solid reasons for investing in high-yield bonds, especially long term. But as you read about what these issues could offer your portfolio, it's also wise to consider how these bonds earned their nicknames.
What's the Attraction?
High-yield bonds were coined "junk" bonds because of their BB or lower rating from major rating services such as Moody's and Standard & Poor's. These ratings are considered below investment grade, due to their issuers' questionable financial situations. These situations vary widely — from financially distressed firms to highly leveraged new companies simply aiming to pay off debts.
All these issuers offer high yields to entice investors to overlook lower credit ratings. But over time, it's these above-average yields — generally 4% to 5% above Treasuries — that have historically paid off for those willing to invest in these firms (though past performance can't guarantee future results).
High-yield bonds may provide diversification for long-term investors seeking to maximize yield and/or total return potential without investing more money in stocks. High-yield issues often move independently from more conservative U.S. government bonds as well as the stock market (see chart).
The Risk Trade-Off
In exchange for their performance potential, high-yield bonds are very sensitive to all the risk factors affecting the general bond market — credit, interest rates, and liquidity.
A high-yield bond's above-average credit risk is reflected in its low credit ratings. This risk — that the bond's issuer will default on its financial obligations to investors — means you may lose some or all of the principal amount invested, as well as any outstanding income due.
High-yield bonds often react more dramatically than other types of debt securities to interest rate risk, or the risk that a bond's price will drop when general interest rates rise, and vice versa.
Liquidity risk — the risk that buyers will be few if and when a bond must be sold — is exceptionally strong in the high-yield market. There's usually a narrow market for these issues, partly because some institutional investors (such as big pension funds and life insurance companies) normally can't place more than 5% of their assets in bonds that are below investment grade.
In addition, high-yield bonds tend to react strongly to changes in the economy. In a recession, bond defaults often rise and credit quality drops, pushing down total returns on high-yield bonds. This economic sensitivity, combined with other risk factors, can trigger dramatic market upsets, as in 1990, when the well-publicized downfall of high-yield bond giant Drexel Burnham Lambert squeezed this market's tight liquidity even more, driving investors away.
The Search for Growth
High-yield bonds have the potential to offer higher returns than investment-grade government bonds. However, on average, high-yield bonds have not performed as well as investment grade government bonds over the long term. This underscores the importance of professional management when making high-yield bonds a part of your portfolio.
Sources: Standard & Poor's; Merrill Lynch; the Federal Reserve. Stocks are represented by the S&P 500. High-yield bonds are represented by the total monthly returns of the Merrill Lynch High-Yield Bond Index. Long-term government bonds are represented by the total monthly returns of long-term (10+ years) government bonds are constructed from yields published by the Federal Reserve. Cash is represented by the yield on 3-month Treasury bills. The S&P 500 is generally considered representative of the U.S. large-cap stock market. All are unmanaged indexes. Index results do not take into account the fees and expenses associated with purchasing individual securities or mutual fund shares, and individuals cannot invest directly in any index. Past performance does not guarantee future results. CS000152.
Look Before You Leap Into High Yields
The risk factors associated with high-yield investing make it imperative to carefully research potential purchases. Some of the factors to consider when buying high-yield issues include:
True junk vs. hidden value — The low credit ratings of high-yield bonds can be due to the issuers' distressed financial status, or simply because the issuer is small and/or highly leveraged and needs to finance debt to maintain rapid growth. These hidden-growth companies are more likely to meet their financial obligations to investors.
Look for companies with improving credit characteristics or the ability to emerge strong from a restructuring or bankruptcy.
A Guide to High-Yield Bond Ratings
| Standard & Poor's BB | An obligation rated "BB" is less vulnerable to nonpayment than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor's inadequate capacity to meet its financial commitment on the obligation. |
|---|---|
| Standard & Poor's B | An obligation rated "B" is more vulnerable to nonpayment than obligations rated "BB," but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitment on the obligation. |
| Standard & Poor's CCC | An obligation rated "CCC" is currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation. |
| Standard & Poor's CC | An obligation rated "CC" is currently highly vulnerable to nonpayment. |
| Standard & Poor's C | An obligation rated "C" is CURRENTLY HIGHLY VULNERABLE to nonpayment. The "C" rating may be used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued. A "C" also will be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that is currently paying. |
| Standard & Poor's D | An obligation rated "D" is in payment default. |
Source: Standard & Poor’s.
Investment costs — Prices of individual bonds can range from $10,000 to $100,000. One survey estimated that obtaining a break on brokers' commissions in the high-yield market means investing at least $25,000.
Fund expenses — Reasearch by Standard & Poor's indicates that mutual funds (including high-yield bond funds) with lower expense ratios have performed better over time than more expensive funds. As you review your fund choices, keep in mind that the average expense ratio for all domestic taxable fixed-income funds is 1.47%. Using this average as a benchmark can help you determine if you're purchasing shares of a fund that is too expensive.
A long-term outlook — The high-yield market has lost as much as 9.6% in a given year, but also gained as much as 46.2% in a single year. Aiming for the market's average annual return means making a long-term commitment.1
A diversified portfolio — Because high-yield bonds carry the same long-term risk as some stocks, your portfolio should also include conservative investments such as municipal bonds and money market instruments.2
Mutual funds — A high-yield bond fund can be an easy and affordable way to invest in this market. Combining several bonds in one portfolio, a high-yield bond fund is inherently diversified against the risk of loss from a single issue. A fund's professional management saves you the effort of researching and evaluating individual bonds; and low initial investment requirements can give you the diversification you need in this higher-risk market at an affordable price.
The total return potential of high-yield bonds makes these issues a terrific way to diversify a portfolio. But remember that "junk" always exists in different degrees in this market and can affect returns from time to time. You will want to pair these bonds with more traditional, conservative investments in your portfolio and keep a long-term perspective. You may also want to talk with your financial advisor regarding the appropriateness of these investments to diversify your portfolio and help reach the longer-term goals you've set.
Points to Remember
- High-yield bonds have grown in popularity due to their relatively high yields, rising credit quality, and diversification potential against high stock market valuations.
- These bonds earn their "junk" labels from below-investment-grade credit ratings (BB or lower) from major ratings services. This means issuers are considered more likely to default on their financial obligations to investors.
- In exchange for higher risks compared with other types of bonds, high-yield issues have historically provided competitive returns averaging about 4% to 5% above those of U.S. Treasury securities.
- Factors to consider when purchasing high-yield bonds include the underlying financial situation of the issuer, the price, and whether you are willing to invest long-term.
- High-yield mutual funds offer an affordable way to invest in a professionally managed portfolio that's diversified across several issues in this market.
1Source: Standard & Poor's. Based on the calendar year returns of the Lehman Brothers High Yield Bond index from 1984 to 2007.
2An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
Financial planning services and investments offered through Ameriprise Financial Services, Inc., Member FINRA and SIPC.
There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Non-investment grade securities, commonly called "high-yield" or "junk" bonds, generally have more volatile prices and carry more risk to principal and income than investment grade securities.
Diversification helps you spread risk throughout your portfolio, so that investments that do poorly may be balanced by others that do relatively better. Diversification is not a guarantee of overall portfolio profit or protection against loss.
Investment products, including shares of mutual funds, are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.