Why High-Yield Bonds Belong in Your Portfolio

Do high-yield bonds belong in your investment portfolio?

Maybe so. Historically, high-yield bonds, often called “junk” bonds by traders, analysts and money managers, primary due to their higher risk levels relative to traditional fixed income instruments, may conjure up disturbing images.

Think Michael Milken, bond department chief at Drexel Burnham Lambert in the 1980s, who was credited with pushing high-yield debt instruments into the mainstream market. Milken grew famous on 100 percent investment returns, only to be indicted on 98 counts of racketeering and fraud in 1989.

Fast-forward to 2016, and high-yield bonds have largely overcome the “dark sheep” stigma that enveloped them in the post-Milken 1990s and beyond.

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Ironically, the Great Recession played a significant role in the increased growth of high-yield bonds and bond funds, even in average investors’ portfolios. The reason? As the Federal Reserve pulled back on interest rates, primarily to spur lending and credit in a sour post-recessionary economic climate investors turned to the high-yield side of the street, where rates of return were higher than fixed-income stalwarts like the 10-year U.S. Treasury note.

This year, in fact, is on track to be at the top of the list for high-yield investments since the Great Recession years, as bond prices have risen roughly 18 percent in the past six months. That’s so, even as bond defaults – the bane of any high-yield investor — have reached a six-year high of 5.1 percent in July.

But investors aren’t paying attention to downside risks, sliding money instead into high-yield investments that are currently offering 5 percent high returns than U.S Treasurys. The numbers speak for themselves. According to Thomson Reuters Lipper, so far this year the high-yield mutual fund sector has seen $6.4 billion in inflows, compared to $47.7 billion in outflows from 2013 to 2015.

Consequently, investors who have sidelined the sector might be wondering if they’re missing the boat high-yield bonds.

They have a point, with a caveat or to, of course.

“High-yield bonds belong in a well-diversified portfolio,” says Daniel Milan, managing partner at Cornerstone Financial Services, in Birmingham, Michigan.

This is true for high-yield corporate bonds as well as high-yield municipal bonds. “While high-yield bonds are a riskier asset class, with higher risk there is the potential for higher yields and higher returns,” Milan says. “That’s important in a low-interest marketplace, as we have been stuck in one for years. A consumer investor, especially one desiring income in retirement, is searching for yield anywhere. Consequently, high-yield bonds can help those investors get closer to their needed averaged yield.”

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Milan notes, too, that while high-yield bonds are traditionally riskier than some other bonds, they have historically outperformed Treasurys, while at the same time exhibiting less volatility than stocks. “Additionally, high-yield bonds positively affect diversification in a portfolio because of their moderate correlation to stocks and low-to-negative correlation to Treasurys,” he says. “Consequently, high-yield bonds are a good small-asset allocation to help minimize equity risk through diversification.”

Others point to key historically patterns linked to high-yield securities — patterns that every investors should know before leaping in, head-first, into the market.

“The difference in returns between high-yield and investment-grade bonds can be easily measured, says Keith Baker, a certified financial planner and professor of mortgage banking at North Lake College in Irving, Texas. “Under normal economic conditions, high-yield bonds generate returns that are between 300 and 400 basis points higher than U.S. Treasurys with similar contract durations.”

Consequently, when the economy is in recession, the difference in returns escalates. “According to a schedule of spreads published by Barley’s, on December 16, 2008, the spread at the heart of the Great Recession was 2,127 basis points higher than U.S. Treasury securities with similar contract durations,” Baker says. “So, investors can lose a significant amount of principal if they had to sell; or if their portfolio of high yield bonds contained too much CCC-rated debt, or if the investment just loses because bond issuers simply fail and don’t pay back the debenture.”

How do you know if the “high-risk, high-reward” theme that comes with high yield bonds is right for you? Baker advises applying the “30 percent test.”

“Most money managers say that if a purchaser cannot hold on through a 30 percent price decline in their high-yield investment, then they should not be in the high yield space,” he says. “Most of my conservative investors would be unwilling to take a 10 percent price decline in a fixed-income security.”

Even with that added risk, high-yield, or lower-rated bonds have placed themselves in a strategic position. “They are bonds, yet, act more like stocks,” Milan says. “Since the low-rated bondholders are second to last next to stock holders to get paid off in light of financial distress, this is the reason why low credit-rated bonds are “high-yield” bonds,” he notes.

“By design, high-yield bonds are the least sensitive to changing interest rates but more to economic growth than other bonds.”

If you decide to make the leap, make sure you’re constantly vigilant about the state of your high-yield investments.

“It really is important that high-yield bond allocations are closely monitored, as at the end of the day they are “junk” quality and do carry higher than normal credit risk,” Milan says.

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Top High-Yield Bond Funds

Stock	Price	1-Year Return
PIA High Yield Fund PHYSX	$10.13	2.0%
Federated Institutional High Yield Bd Fd FIHBX	$9.85	2.87%
Vanguard High Yield Corporate Fund VWEHX	$5.85	2.38%
Lazard US Corporate Income Portfolio LZHYX	$4.88	2.47%
Westcore Flexible Income Fund WTLTX	$8.89	4.26%
TCW High Yield Bond Fund TGHYX	$6.26	2.72%
Payden High Income PYHRX	$6.49	1.61%
Eaton Vance High Income Opportunities ETHIX	$4.47	1.73%
Fidelity® Capital & Income Fund FAGIX	$9.58	2.13%
TIAA-CREF High Yield TIHYX	$9.62	0.91%