High-yield bonds, or “junk bonds” as they’re also known, are often given a wide pass by non-institutional investors either because they don’t know much about them, or because they’re believed to be risky investments. Much like pit bulls, high-yield bonds have an undeservedly poor reputation.
Many top companies, including some whose stock you may own, issue debt – known as bonds – as a means of raising capital. (And when I say “top” companies, we’re talking the likes of Chrysler Group, Levi Strauss, Expedia, Sprint, Revlon, and Burger King, among many others.) In my opinion these debt-issuers have good cash flow and are generating revenues. They are companies you see every day.
Sometimes businesses go through a bad cycle or two for any one of a thousand reasons. That causes rating agencies to downgrade the corporate debt to below investment grade. Now, in my opinion, it doesn’t necessarily mean these enterprises are going away anytime soon. Nor does it make investing in their debt a poor decision. In fact, high-yield debt is exactly that – “high yield,” meaning it pays investors more than investment grade bonds. Why? Because, well, these companies have difficulty raising money from investors when they’re are exactly “hitting it out of the park.”
If you’re with me so far, we’ll dig a little deeper.
I believe high-yield bonds are only loosely connected to their investment-grade peers, or to stocks for that matter. Remember how I explained they pay more than investment-grade bonds? This is a good thing, because it makes high-yield bonds less susceptible to interest rate swings. Their coupon payments help damn price volatility. However, they do share something in common with stocks in that they also rely on strong economic growth.
This low correlation makes high-yield bonds a worthy addition to your investments since they could help lessen overall risk in a well-diversified portfolio. You still get the same amount for you coupon payment whether it is a downward or upward trending market.
While I do believe that high-yield bonds have a place in your portfolio, I don’t want to leave the impression they’re completely without risk. They’re investments after all, and investments all have some form of risk.
Specifically I believe, high-yield bonds can be volatile, and during bull markets they could generate substandard returns. There’s also the possibility that companies could default on their debt obligations. Investors, however, can take some solace in a recent report from Moody’s Investors Service that says default rates should be around 3.2% by year-end 2013, near historic lows. By comparison, the average default rate since 1993 is 4.5%, the peak, in 2009, a whopping 14%.
About Austin R. Berkelhammer
Austin Berkelhammer is Head Trader at HFP Capital Markets where he’s responsible for trading and back office activities for the firm’s Private Wealth and Institutional Groups. Prior to joining HFP Capital Markets in 2011, he served as a trader at Flagler Funds and Deutsche Bank. Mr. Berkelhammer holds a BS degree in Economics from Hofstra University and is an MBA candidate at the University of Maryland’s Robert H. Smith School of Business. He holds his Series 7, 63, 53, & 55 licenses.