High-yield bonds: Not as safe as you might think
Getting a high yield on an investment sounds pretty good, doesn’t it? Many investors would flock to an investment that had that term in its name.
For example, the iShares iBoxx $ High-Yield Corporate Bond exchange-traded fund advanced more than 5 percent in the past two months. This fund tracks an index of bonds rated below-investment-grade and have a year or longer until they mature.
So … what does that really mean?
Bonds are simply debt issued by companies or municipalities to raise money for a project. If investors hold these bonds until the maturity date, they receive their principal back, along with the promised interest rate.
Some companies are well situated to pay their bondholders. The big ratings agencies, such as Moody’s and Standard & Poor’s, classify the debt of companies likely to pay as investment grade. Companies in financial trouble are less likely to repay investors, and their debt is deemed non-investment grade.
Wouldn’t you demand to be paid a higher interest rate to lend money to a company that has a higher likelihood of default?
That’s where a high yield comes into play. Debt issued by financially strapped firms offers a higher interest rate to attract investors. Hence the higher yield.
For companies promoting mutual funds and exchange-traded funds, the term “high yield” is a marketing gambit. The term sounds like a no-brainer: Who doesn’t want a high yield on their investment?
But there’s a catch. The other term for high-yield bonds may sound more familiar: junk bonds.
Not long ago, I met a woman who wanted some insight into her stock-and-bond allocation. She made it clear that she wanted a conservative portfolio that could withstand a severe market downturn with minimal damage. She insisted she wanted nothing to do with junk bonds.
As I reviewed her holdings, I realized quickly: Her portfolio contained not one, not two but three junk bond funds. She didn’t know this because the funds all had “high yield” in their names. Doesn’t that sound much better than “junk?”
I’ve already alluded to the higher risk inherent in these junk bond funds. These bonds tend to behave more like stocks in terms of their price performance. While junk bonds trended significantly higher over the past two months, investment-grade bonds were more or less stagnant.
Guess what other asset class zoomed higher in January and February? If you guessed stocks, you’re right. Stocks and high-yield bonds are riskier investments than investment-grade bonds. As such, they have, over time, paid more. But they also are more volatile.
Every investment is risky; there is no such thing as the “safe” investment that pays a high return (sorry to burst anyone’s bubble). I understand many investors want to play catch-up if they are starting late, as is the case with many baby boomers. However, there is no magical allocation to generate fast growth with low risk.
So what should you do to generate the return you need, if you’re concerned that you started late or may not have saved enough?
First, if you are approaching retirement, ask yourself some important questions. What do you need to sustain your lifestyle? For many years, conventional wisdom held that expenses in retirement are around 85 percent of those pre-retirement. If anybody, such as a stock broker, financial planner or some genius on the internet, tries to tell you that, tune them out. It’s nonsense. After you retire, it’s very likely that some of your expenses will go up, particularly in the early years when you want to travel and have some fun while you are still young enough to enjoy it.
Then figure out what kind of investment return you’ll need to generate that income. Ask yourself what kind of tax-efficient withdrawal strategy is best for your situation. How much risk is appropriate to get the return you’ll need, especially when you are no longer working and have less opportunity to make up potential market losses.
Turning to high-risk investments, such as junk bonds, may seem like a quick fix, but it can have devastating effects in a poor economy or downward-trending market. Trying to get the highest possible return without corresponding attention to risk levels is a fool’s errand, and one that is easily avoided.
Kate Stalter is president, senior adviser and market strategist at independent, New Mexico-based asset-management firm Better Money Decisions. For a no-obligation portfolio risk assessment, contact Kate at 844-507-0961, ext. 702, or firstname.lastname@example.org.