Should you Stretch for Income in High Yield Bonds?

by Josh Hahn on October 24, 2012

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As fixed income investors search for more returns, high-yield bonds are getting increased attention, especially as interest rates remain at historical lows. Sometimes referred to as “junk” bonds, these non-investment-grade assets offer higher returns in exchange for more credit risk. Issuers of high-yield bonds have a rating of BBB or below from Standard and Poor’s, or Baa from Moody’s, and they have a higher perceived risk of default than their blue chip counterparts. Investors in this asset class carefully weigh the risks of the underlying issuers before buying a security or investing in a mutual fund. However, the asset class is attracting new investors as there is growing concern about inflation adjusted returns in otherwise safe fixed income asset classes. Specifically, investors are becoming unsatisfied with the very low yields of U.S. Treasury and blue chip corporate debt.

However, some experts are concerned that low interest rates and increased attention in this sector is driving too many investors into the asset class, and current yields may not adequately reflect risk. This is highlighted by a EPFR Global third quarter report that says there was a net inflow of $19.3 billion in high-yield bond mutual funds in the third quarter, which was the second highest amount it has recorded. Also, a report from Dealogic points out that over $247 billion in bonds were sold in September alone. This may mean that the opportunity for new investors is slimmer than earlier in the year. However, current yields are still at roughly 6.40%, so the returns may still be attractive enough to consider.

As more capital chases these high-yielding bonds, weaker companies may choose to issue new debt to take advantage of the low rates and competitive demand. If investors are distracted by the yield, they may not take a prudent look at the company fundamentals. For example, a Wall Street Journal article cites that the pet retailer Petco, recently sold new bonds in order to pay interest on previously issued bonds. Another report from Bloomberg BusinessWeek highlights that Standard and Poor’s pegs the default rate for Caesar’s Entertainment Corp. at 27% in August, up considerably from the year earlier. As a bond holder this should be a cause for concern regardless of the yield. But those who are bullish on high-yield bonds suggest that the quality of non-investment grade corporations is improving, mostly because of increased earnings and lower debt service costs. Petco and Caesar’s may be extreme examples, but they are reminders that mutual fund investors should take a close look at the individual holdings within a fund. This can often be found by reviewing the fund prospectus or searching for the ticker symbol online.

In addition to credit risk, fixed income investors should be reminded of liquidity or call risk. For example, if you hold an individual corporate security and the company is facing financial difficulty, you may have a difficult time finding another buyer. Or if the company is doing better than expected, they may decide to buy back the bond, leaving you without the high yielding asset. Whatever the case, investors must consider the risks other than credit.

However, if investors are willing to take on these risks, there are alternatives to domestic junk bond issuers. Specifically, there are additional opportunities in emerging market debt, through both corporate and sovereign debt. For example the Blackrock Emerging Market Debt mutual fund (BREDX) has returned approximately 16% YTD with sovereign debt exposure to countries such as Russia, Turkey, and Venezuela. Investors in this type of fund may achieve yield expectations as well as diversify currency risk. Many experts suggest that developed economies such as the U.S. and Europe remain a safe haven investment even in the midst of their financial difficulties, and this can lead to opportunities in other countries.

It seems clear that investment grade fixed income returns will remain at very low levels, even though these investments may not produce real returns. Investors particularly concerned with this issue may not be left with many options. As a result, there may be a case for exposure to high-yield bonds so long as the risks associated with this asset class have been considered.

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This post was written by...

– who has written 2 posts on Excess Return.

Joshua is an experienced finance professional with a keen interest in personal finance and investing. He is a private banker to investment clients and a freelance writer focusing on common sense investment insight. Joshua is especially concerned that investors have a solid understanding of an investment product before initiating a position.

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