A high-yield bond — a noninvestment-grade bond, speculative-grade bond or junk bond — is a bond that is rated below investment grade, or below BBB- (Standard & Poor’s/Fitch). High-yield bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than investment-grade quality bonds to make them attractive to investors. For investors searching for current income, today’s low interest rate environment provides few options.
There are several aspects of high-yield bonds that make them interesting as an investment choice today. First, because interest rates are so low, both from quality and maturity perspectives, high-yield bonds are just about the only bonds that are paying attractive rates of interest. Those in high tax brackets may point to municipal bonds. However, these bonds have also risen dramatically in price, with their yields falling just as dramatically. Additionally, many municipalities, especially in California, are suffering with lingering economic troubles due to the long-lasting recession, which many are still experiencing.
Another interesting characteristic of high-yield bonds is that they trade more like equities than bonds. (In this context, I am specifically discussing high-yield corporate bonds.) Historically, high-yield corporate bonds have been more highly correlated with stocks, so it is a good idea to understand the stock market direction and expectations, and then apply one’s research on stocks to the high-yield market when making investment selections.
With an improving economy, high-yield bonds offer the added benefit of possible upgrades in their credit ratings, which can enhance the returns of these investments significantly. As the economy improves, companies tend to perform better financially, paying down their debts and raising their cash balances, improving their balance sheets and thereby improving their credit ratings. When companies have their credit ratings upgraded, the perceived risks of the company diminish, and the prices of their outstanding bonds tend to rise.
High-yield bond spreads — the difference between the yields on high-yield bonds and the yields of treasuries — exploded when the stock market and financial markets crashed in late 2008 and early 2009. Spreads at that time spiked to about 20 percent. This, of course, means the prices of high-yield bonds plummeted as investors ran for the exits in the wake of the bankruptcies and failures of the likes of Lehman Brothers, Bear Stearns, Merrill Lynch and so many others. Investors just didn’t want to own anything risky, and they sold high-yield bonds en masse.
Since then, high-yield bond prices have made a significant rebound, rallying dramatically into the end of 2009 and through 2010. High-yield bonds currently offer an average yield of 7.175 percent, and the average high-yield risk premium — the spread between treasuries and high-yield bonds — is down to 6.15 percentage points. The high-yield bond has appreciated a remarkable 4.29 percent so far in 2012.
Retail investors have plowed $11.8 billion into high-yield bond mutual funds this year, compared with $4.8 billion for stock funds and $9.9 billion for investment-grade bond funds, according to research firm Lipper. Mutual-fund managers say they are also increasingly buying up junk bonds, or bonds of companies with below-investment-grade credit ratings.
Is it too late to buy high-yield bonds?
This is a great question. My answer is no, but ... the opportunities to make easy money in this asset class are long gone. Those seeking current income typically are fairly risk averse — retirees not looking to take significant risk, and sometimes not in a position to suffer a substantial loss of principal should anything go wrong. Companies with high-yield or junk status are rated this way for good reason: their balance sheets are usually debt-heavy and their free cash flow may be unstable and low in comparison with their fixed obligations. Investors will have to do their homework to find good investment candidates, but from what I see, there are good opportunities still available.
In addition to the unique combination of very low interest rates and the still strong spreads between treasuries and other bond types and high-yield corporates, we are at the “sweet spot” in the economic cycle for high-yield bonds. This is the perfect time to buy these bonds, just as the economy is starting to show real, measurable, sustainable signs of growth.
Going forward, we should see an increasing rate and volume of credit upgrades for U.S. companies as the economy begins to stretch its legs. This is the ideal time to own what I consider to be good companies that are currently sitting at junk status, but that have good chances of being upgraded, some into the investment grade area, within the next few years.