High yield bonds, also known as “junk” bonds, have always had an identity crisis. They show up in our portfolio reviews under the category of “bonds”, but in reality, they move more closely with the stock market than the bond market. They’re an investment that has some characteristics of bonds and some of stocks – and may be an important part of your portfolio.
What are junk bonds? Like all bonds, they’re long-term IOUs from companies to investors. Just as individuals with poor credit have to pay high interest rates, so do companies. And when a company’s credit rating is low enough, Wall Street calls those IOUs junk bonds – or, more genteelly, high yield bonds. Sometimes distressed companies issue junk bonds, but sometimes the issuers are companies on the rebound from hard times, such as telecommunications companies like Sprint or hospital operator HCA.
Anything rated BB or lower is considered high yield (junk) versus BBB or higher, which is investment grade.
Why are they called junk? Because they have higher risk of defaulting. The long-term default rate for junk bonds is about 4% and can spike over 10% as it did in 2009
A lot of investors avoid high yield bonds: When compared to traditional bonds they seem like a gamble. And they ARE riskier than high-grade bonds. But if you think of them as we do – as a less volatile exposure to corporate growth —you’d see an investment that finds risk and return levels in between bonds and stocks.
How can a bond be like a stock? After all, when you buy a bond, you’re a lender. You want predictable interest payments and your principal back when the loan term is over. On the other hand, when you invest in a stock, you’re an owner – you own a percentage of a company, and share a proportional part of the company’s earnings and dividends. They’re very different creatures.
Yet high yield bonds suffer from identity issues, and have more of the risk characteristics of stocks. As we look at the up days and down days of both stocks and bonds, the high yield bonds move more in alignment with the patterns of stocks than bonds.
How do we know this?
Because we can measure it!
Correlation. It measures how much one investment zigs and zags with another investment over time. Some investments have a correlation of 1, which means they move together perfectly in sync. (Rain and umbrella sales is a good example of high correlation.) Some have a correlation of -1, which means they move perfectly in sync—but in opposite directions. A correlation of 0 means they have absolutely nothing in common and they’re moving to the beat of their own drum.
High Yield bonds historically have a correlation of .71 with stocks, and a correlation of .17 with traditional bonds, meaning they move much more closely with stocks than bonds. Why? Loans to lower-quality companies will fluctuate more based on the companies’ growth prospects and the economy (similarly to stocks) than traditional, high-quality bonds, which tend to fluctuate more with interest rate changes and inflation expectations.
The better the economy, the greater chance that the business climate will be better and the “junk” companies will pay back their loans.
In today’s world, most stocks are expensive relative to history. Meanwhile traditional bonds are paying very little and have their own sets of risks. High Yield bonds serve a role as a hybrid- the “stuff in between.” While they will tend to decline when stocks do, and rise when stocks do, they also carry above-average yields that can cushion declines. So while they will still show up in the bond portion of your portfolio reviews, we think of them as a less volatile exposure to stock risk.
Many investors may be surprised to learn they own “junk” in their portfolios. These aren’t just bonds with a juicier yield; they also carry a different type of risk. Because junk bonds are more risky than traditional bonds, it may be prudent to reduce risk elsewhere in the portfolio when investing in high yield bonds.
As a client of Glassman Wealth, you need to know what it means to have these high yield bonds in your portfolio. You own it, and you should know it!
If you’d like to learn more and read a fascinating (and easy to read) 10-year analysis from Lord Abbet, click here!