Time to be careful with high yield bonds

High yield corporate bonds are sometimes called “junk bonds.” This less than glamorous description comes from the fact that these types of bonds are issued by corporations that aren’t the most credit-worthy. Buying a bond from a stable large company (think IBM, Microsoft, Apple, etc.) gives a very high chance that the semi-annual interest payments will be made without fail during the life of the bond and the principal value will be paid back to the investor when the bond matures.

Contrast that with buying a bond from a smaller, less financially sound company, which is more dependent on the strength of the economy to survive. In this case the smaller, less-stable company has to pay a higher rate of interest to borrow from investors due to the risk that things may not go as planned. Interest payments could be missed or, in the worst case, the principal value of the bond may not be fully repaid.

It easy to ask, “Why would anyone buy a high yield bond?” The reason is that over time, most of these bonds are successful and pay enough extra interest to investors to account for a few failures along the way and still come out ahead. High yield bonds usually pay an average of 5 to 6 percent higher interest than bonds from the larger well-established companies. This difference in yield is known as the “spread”. Over time, high yield bonds have provided returns equaling about 75 percent of the stock market’s average annual return, with about 50 percent of the volatility risk. This is an attractive risk-reward scenario, but timing is important.

When bond investors are fearful of defaults, prices on junk bonds drop. The interest rate spread between high quality bonds and high yield bonds widens, and may reach 10 percent or more. Historically this has been an attractive time to buy these lower credit quality bonds and wait for economic conditions to normalize.

Today, we have the opposite occurring. Investors are hungry for yield in the current low interest rate environment and have bid up the prices on high yield bonds to a level which in the past has signaled danger. Spreads are currently running in the 3 – 4 percent range compared to the historical norm of 5 – 6 percent. Many high yield bonds are trading at prices above the par value at which they will mature in the next few years, meaning the prices have to decline as the maturity date approaches. Quite simply, the risk of owning junk bonds has risen significantly.

We can’t predict the future, but history has shown that every time levels like this were reached in the past, things didn’t go so well for high yield bond investors as prices declined substantially. I suggest reviewing the level of risk you are taking in the fixed income portion of your portfolio and make adjustments if necessary. Likewise, watch for opportunity down the road after spreads widen and bond prices are attractive again.

This story was originally published September 11, 2017 at 2:04 PM with the headline "Time to be careful with high yield bonds."