Advisers will often throw high-yield bonds into your portfolio because the name “high-yield” sounds good, doesn’t it? Everyone wants higher interest rates and more return. But people don’t realize there is more risk when it comes to more return.
We have to be strategic when building a portfolio, balancing the risk and return. We can’t throw just anything into our portfolio without considering how it will affect all of the other parts.
High-yield bonds seem more attractive, but they end up messing with your portfolio in some significant ways, as we’ll see below.
How do you get more return from bonds?
First, we want to look in more detail at where we get more return from bonds, and then we’ll see why this doesn’t fit with our overall portfolio strategy.
One way to get higher returns from your bonds is to lend money to riskier companies. These types of high-yield bonds are called “junk bonds.” When you buy a bond, you’re lending money to a corporation or government. With junk bonds, you’re lending money to a corporation in distress. For example, they might be poorly managed, have low sales, or have high debt.
Because the company is struggling, they must pay you a higher interest rate, otherwise what’s the point? Think about it, if you had the option of lending money to Apple or to Bob’s candy shop—where Bob doesn’t know a balance sheet from a candy wrapper—which one are you going to choose?
Well, if they both offer the same interest rate, Apple, of course! But what if Apple will pay you 2% in interest while Joe will pay 10%? Now it’s a more interesting decision. That’s the trade-off with junk bonds: low interest rate with safety and security or high interest rate with higher risk.
We can tell whether a bond is considered a junk bond or not by looking at its credit quality. Independent rating agencies examine a company and rate it based on their financial strength. Junk bonds are rated “BB” or lower by Standard and Poor’s and “Ba” or lower according to Moody’s. See the chart below:
Another way to receive better returns when investing in bonds is by pushing out the maturity further. Maturity is a measure of how long before the company must pay back your money. It’s the length of time between the issue date and the “maturity date,” or the date when the money is due. It can be anywhere from one month for short-term bonds, or thirty years for long-term bonds.
In between the issue date and maturity date, most bonds pay interest in “coupon payments.” For example, a $1,000 bond with 2% interest will pay $20 per year (usually in semi-annual payments of $10). These payments are the coupons.
Bonds with longer maturities have more risk because your money is locked up for a longer period of time. All things equal, I’ll be more willing to lend my money for six months than 30 years because there’s not much can happen in six months, but who knows where this company will be at in 30 years?
To compensate for this risk, companies typically must pay higher interest rates for bonds with longer maturities (although it doesn’t always work out that way).
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Why do you buy bonds?
To understand why we don’t want high-yield bonds in our portfolio, we have to go back to the purpose of bonds—safety. High-quality bonds don’t offer high-paying interest rates, but they do offer safety.
When the economy is struggling and the stock market is dropping, investors become fearful. When investors are fearful, they “flee to quality,” they get out of stocks and buy safer investments—like high-quality bonds—which drives the prices of these bonds up.
This protection against downturns is one of the key reasons we want high-quality bonds in our portfolios. There are other reasons too, but I’ll save those for another time.
The problem with junk bonds
In short, junk bonds don’t provide safety. Risky companies might be able to keep up on their interest payments while the economy is good and people are buying their products, but once the economy goes into a recession, their risk of default on their debt skyrockets. Their business may decline, and because their margins are so low, their debt can collapse on them.
In the recessions of 2002 and 2008, some high-yield bond portfolios had negative returns as low as -50%. Right when you need bonds the most is when junk bonds can fail you.
Many people can get antsy with their high-quality bonds when they see years go by of 2% returns. It can be tempting to opt for the 6% or 7% returns of junk bonds. But those who stayed disciplined were rewarded in years like 2002 and 2008, where everything in the market was going down, but safer AA and AAA rated bonds went up 13% and 16% during those market declines.
The problem with longer maturities
Longer maturity is not the answer either, because it exposes the investor to what is called “interest rate risk.” Interest rate risk is the possibility of a bond losing value from an increase in interest rates. Bonds and interest rates have an inverse relationship. When interest rates rise, the price of bonds fall, and when interest rates fall, the price of bonds rise.
So the longer your bond has until maturity, the more likely it will be affected by a change in interest rates. If my bond has six months until maturity and interest rates rise, I only have to wait six months before I can reinvest in the higher-paying bonds. But if my bond has 30 years left, I’m stuck in the lower paying bond for a long time.
This increased risk from interest rate fluctuations takes away the safety I need from bonds in my portfolio.
Don’t fall for the allure of higher returns when it comes to bonds. Stay disciplined and remember the purpose of bonds in your portfolio—safety.
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By Paul Winkler
*Advisory services offered through Paul Winkler, Inc. (‘PWI’), a Registered Investment Advisor. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities.
