Weighing the Hazards in High-Yield Bonds

With savings accounts and high-quality bonds offering miniscule rates of return, many investors are widening their search for income-producing investments. Among the most popular moves: buying junk.

Despite the unsavory nickname, junk bonds -- more formally known as high-yield bonds -- are seen as pure gold by many yield prospectors. During the first quarter of 2012, investors plowed $31 billion into high-yield bond funds, according to research firm EPFR Global. That exceeds any other category and is almost four times the global demand for junk-bond funds in all of 2011.

The appeal is obvious: generous payouts at a time when most other fixed-income options aren't even matching the inflation rate. “Clients are essentially trying to replace the income they used to get from their government bonds,” says Hans Olsen, head of investment strategy in the Americas for Barclays Wealth. BlackRock’s $14.3 billion IShares iBoxx High Yield Corporate Bond Fund, the world’s largest junk-bond exchange-traded fund, offers a yield of more than 7 percent.

Replacing super-safe income sources with junk bonds means adopting a very different risk profile. “The market’s kind of tricky now,” says Robert Levine, a veteran junk-bond trader who wrote the forthcoming book “How to Make Money with Junk Bonds.” “Everyone is recommending junk bonds,” he adds, but they require extra research and care. “It’s not a no-brainer.”

False Security

Investors looking at trends in the high-yield debt market today might get a false sense of security. Finances at indebted companies are improving, and defaults on loans are low. Moody's says global speculative-grade debt defaulted at a rate of 2.3 percent over the past 12 months, down from last year's first quarter reading of 2.6 percent. The ratings company expects the rate to rise to 3 percent by year-end.

Even with a forecasted increase, default rates are low. In other words, the biggest risk in junk bonds isn’t that they’re junk. Yes, a new recession or financial crisis could scare investors and bankrupt more junk-status companies. Such a jolt, however, would need to be severe to seriously undermine the case for high-yield. BlackRock estimated last month that default rates would need to triple to justify current yields.

Instead, the biggest risk facing junk bonds may be simply that they’re too popular. In recent years the prices of many bonds have been bid up to extremely high levels (hence all those low yields). If and when interest rates rise, bond prices -- including those of junk bonds -- could take a tumble.

Rate Risk

Interest rate risk hasn’t troubled investors much since the Federal Reserve slashed rates in 2007 and 2008. To further stimulate the economy, Fed Chairman Ben Bernanke has promised to keep rates low through 2014.

Bond markets don’t always follow the Fed in lock step, and significant improvement in the economy could send overall interest rates higher and bond prices lower. It’s already happened in a small way: The yield on the 10-year Treasury note rose as high as 2.4 percent in March from 1.88 percent at the end of 2011. After several years in the basement, “interest rates have nowhere to go but up,” says Paul Jacobs, a financial planner at Palisades Hudson Financial Group.

It’s true that high-yield investors need to worry less about rising interest rates than other fixed-income investors. That's because a high-yield bond's value is greatly determined by the creditworthiness of the company issuing it. Low-quality junk bonds will rise and fall on bankruptcy rumors, not interest rate trends. Levine notes, however, that because of all the interest in junk bonds, the highest-quality junk bonds are already trading extremely close to Treasuries.

Investors can try to buy protection against interest rate risk via lower-quality junk bonds, i.e., those issued by the most troubled companies, which must in turn pay the highest yield. Of course, that heightens the credit risk since these low-quality junk bonds are the most likely to default. (In reality, individuals almost always trust fund managers to make buying decisions on individual bonds. It’s both difficult and foolish for nonprofessionals to buy individual bonds, advisers say, so they recommend mutual funds or exchange-traded funds.)

Floating-Rate Loans

Because of high-yield bonds’ recent popularity and the threat of higher interest rates, some investors are looking even farther afield for income. George Rusnak, national director of fixed income at Wells Fargo Private Bank, touts the advantages of floating-rate bank loans, which benefit from rising interest rates and inflation while providing income. Palisades Hudson's Jacobs agrees, recommending the Fidelity Floating Rate High Income Fund to clients. It has yielded 3.4 percent over the past 12 months. (Expenses are 0.71 percent.)

Another option is to lighten up bond exposure and buy stocks. That’s a “tough sell” to many clients still stung by the market downturn of 2007 to 2009, says David Joy, chief market strategist at Ameriprise Financial. The advantage of high-yield bonds is that they have about half the volatility of stocks, he adds.

As with any investment, high-yield bond’s popularity could be its downfall -- eventually. “There is a lot of money rushing into this space right now,” Jacobs says. “As quickly as it came in, you could see that money flow out."

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