Income-oriented investors hungry for higher yield have long been lured to the wild side, and high-yield bonds are always beckoning. Sometimes “junk” bonds pay off with handsome interest earnings. Other times investors are hammered by falling bond prices or defaults.
Today’s conditions are a head scratcher, leaving experts with mixed views on junk bond prospects.
“A robust economy is a mixed bag for high-yield bonds,” says Robert R. Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“As the economy improves, the likelihood of the companies being able to make payments on the junk bonds rises, and that is good for junk bond holders. However, as interest rates rise, the value of those future cash flows falls and that negatively impacts the value of all bonds — including high-yield bonds.”
[See: 7 ETFs to Buy as Interest Rates Rise.]
Still, there’s money to be made if things go right. Johnson says that from 1983 through 2013, the return to high-yield bonds averaged 9.46 percent, compared to 7.3 percent for Treasury bonds. Return combines price changes and interest earnings.
The Bank of America Merrill Lynch US and Global High Yield Indices show yields averaging nearly 6.3 percent, about triple that of the 10-year U.S. Treasury. The SPDR Bloomberg Barclays High Yield Bond Fund (ticker: JNK), an exchange-traded fund that’s an easy way for beginners to get into this market, pays nearly 6 percent.
Should the ordinary long-term investor take the plunge?
“If interest rates rise gradually and economic growth remains on track we would expect high-yield bonds to outperform,” says Chris Kim, chief investment advisor at Tompkins Financial Advisors in Ithaca, New York. “The challenge high-yield investors face is if the [Federal Reserve] raises interest rates too quickly, it could upend economic growth and cause an increase in default risk, recession, etc.”
All things considered, Kim feels high-yield bonds are a good bet today.
“In our view, high-yield bonds are more sensitive to economic conditions than interest rates,” he says. “Rising interest rates can be a bit of a headwind for bonds in general but high-yield investors tend to be much more concerned about economic conditions. High-yield bonds tend to underperform during recessionary periods but offer much lower interest rate sensitivity during rising rate periods.”
High yield versus junk bonds. The term high-yield is an upgrade for what is also termed junk bonds. They are bonds issued by companies considered so shaky as to be rated below investment grade. Issuers are at risk of defaulting — failing to make interest payments or to return bondholders’ principal when the bonds mature. Because of the risk, issuers must pay higher yields to attract buyers.
High-yield bonds are considered a fringe investment best left to those willing to do a lot of homework. Junk is not an alternative to Treasurys and investment grade corporate bonds. They are for the risky part of the portfolio, along with stocks and alternative investments that can fly high or crash.
Like all bonds, high-yield bonds are affected by changes in interest rates. If prevailing rates rise, bond prices fall, because investors prefer newer bonds that pay more. What you earn in interest could be wiped out by a falling bond price. On the other hand, falling rates make older bonds more appealing, driving prices up.
[See: 9 Ways to Invest in America With Bond Funds.]
In fact, the JNK exchange-traded fund has lost nearly 1 percent this year despite its attractive yield, and it has returned an average of only about 6 percent a year for the past decade, according to Morningstar. Investors willing to take risk would have done better in stocks. The Vanguard 500 Index Fund ( VFINX), tracking the Standard & Poor’s 500 index, has returned an annual average of 9.6 percent over that period.
How will junk bonds perform? Johnson says junk bonds have done substantially better during periods of falling interest rates than when rates are rising, as they are now.
“The returns to high-yield bonds was 12.4 percent during expansive periods compared to the return on T-bonds of 7.3 percent during expansive periods,” he says, noting that junk beats Treasurys by a much smaller margin when rates are rising. “This indicates that the greater reward that investors achieve for assuming the risk of holding high-yield bonds can be attributed almost entirely to the outstanding performance of those bonds in expansive conditions.”
Rising interest rates can therefore pose a serious threat, Johnson says.
“With the expectation that interest rates will rise over the next year, and over the next few years, I believe that investors in high-yield bonds will likely be disappointed with their returns,” he says.
Stephan Unger, assistant professor of economics at Saint Anselm College in Manchester, New Hampshire, agrees.
“High-yield bonds are facing hard upcoming times,” he says. “In times of rising interest rates, it’s never good owning bonds because new issuances would get you a higher yield. Furthermore, a global sell-off of risky bonds will have an adverse effect on bond prices.”
But the economy’s health also comes into play, as companies operating in a more benign environment are less likely to default. But which is more important: the benefits of a strong economy or the threat of rising interest rates?
“The economy’s strength does make high-yield a safer bet in the face of rising interest rates,” says Scott Ellis, corporate securities specialist at Penn Mutual Asset Management in Horsham, Pennsylvania. “If the strength in the economy helps boost earnings for high yield corporations, the improvement in cash flow will help bolster interest coverage and provide more comfort to investors that their coupons and principal will be paid on time.”
The bottom line on high-yield bonds. Before plunging in, investors should think about whether they can hang in long enough to wait out any downturns, just as they would with stocks. Johnson notes that junk bonds are nearly twice as volatile as Treasury bonds.
“The performance of junk bonds across monetary policy environments roughly mirrors the performance of the stock market,” Johnson says.
[See: The 10 Best ETFs to Buy for 2018.]
Buying individual junk bonds can be very tricky, requiring all the analysis one would do for an individual stock. Ordinary investors therefore often use mutual funds or exchange-traded funds, to leave the picking to the pros.
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Where High-Yield Bonds Can Fit in a Portfolio originally appeared on usnews.com
