Yahoo Finanzen How to Know When High-Yield Bonds Are a Good Investment
Every day, in bull or bear markets, an investor can find recommendations of stocks to buy. In comparison, lists of bond-investing ideas are few and far between. But like stocks, not all bonds are the same. Some are riskier than others.
A particularly risky category is high-yield bonds. These are debt instruments issued by companies that bond raters believe have a higher likelihood, relative to others, of defaulting on payments.
The most prominent bond rating organizations are Moody's, Standard & Poor's and Fitch. These firms using ratings scales to designate credit quality, or likelihood of either payment or default, for a particular bond. "The lower the rating, the higher the credit-default risk, according to the rating agencies' assessment," says Greg Zappin, managing director and portfolio manager with Penn Mutual Asset Management in Philadelphia.
The highest bond rating is AAA and the lowest is D. Bonds rated Ba1 by Moody's and BB+ by S&P and Fitch are considered below investment grade, or high yield. "According to statistics compiled by the rating agencies, default percentages are much higher and recovery amounts are much lower for high-yield bonds than investment-grade-rated securities," Zappin says. That means the high-yield bonds are inherently more risky.
With bigger risk comes bigger rewards. However, an investor considering high-yield bonds must decide whether he or she is being adequately compensated for the extra risk. "The trade-off is not just higher volatility for higher returns. There is real default risk and principal loss at stake when investing in individual high-yield securities. Another consideration is liquidity. This is an issue for all fixed-income markets, but can be more pronounced in the high-yield market," Zappin says.
Those higher returns are, understandably, a lure for investors who are frustrated by the sleepy nature of investment-grade bonds.
But is it worth taking the extra risk of high-yield bonds, or "junk bonds," as they are popularly known?
"High-yield bonds have grown tremendously in the past 25 years. They are now a legitimate asset class, and some portion rightfully belongs in a fixed-income portfolio, regardless of your age," says Freddie Offenberg, partner and portfolio manager with Andres Capital Management in Berwyn, Pennsylvania.
High-yield bonds currently available are issued by well-known companies including Sprint Corp. (S), Revlon (REV) and J.C. Penney Co. (JCP).
"Investors should recognize high yield has a closer correlation to equities than investment-grade bonds," Offenberg says. "High-yield bonds have suffered in price this year, as investors worried about the possibility of a looming recession, lower credit quality and higher interest rates. If you believe we are not facing a recession, then there are many good bargains in the overall high-yield sector."
Look at the sectors. Offenberg says investors should be more judicious when eyeing certain sectors for opportunities in high-yield bonds.
"In the energy and mining sectors, junk bonds are trading as though default rates will be rising significantly, which many experts believe is indeed likely to happen. To invest here, you need familiarity with credit quality and how a company will manage through a very distressed commodity-price environment. These are complex factors, so the timing, proportion and maturity of any high-yield bonds you own are best discussed with a professional investment adviser," he says.
Several mutual fund providers, including Pimco, Loomis Sayles, Fidelity, American Funds, T. Rowe Price and Putnam offer high-yield products.
For investors who desire income and can accept more volatility than traditional bonds, high-yield bonds may be a sound choice, says Jerry Slusiewicz, principal wealth manager at Pacific Financial Planners in Laguna Hills, California.
However, he advises against bond funds, favoring individual bond holdings.
Individual bonds have maturity dates. Because the holdings within a fund have varying maturities, there is no particular date on which investors can expect to be repaid.
While interest rates are unusually low, a bond with a fixed rate of return, held until its maturity date, won't be affected by interest-rate fluctuations. Investors will still have their principal returned and will continue to receive the income stream they are counting on.
What happens when interest rates go up? Slusiewicz says a rising-rate environment could mean investors are in for a shock. Fund investments, he says, have worked out well over the past three decades, as rates have generally been trending lower. "That environment may change very soon, and many investors are going to learn a very tough lesson about the differences between the investor holding the individual security versus not owning any maturity date at all because the fund owns those individual securities. So I do not recommend anyone buy a high-yield bond fund at this time," Slusiewicz says.
Investors should not underestimate the risks of high-yield bonds, even if they appreciate the potential upside.
"Default rates are the bugaboo for junk bonds. You may not get all your money back in a default. There are variations on exactly how much you may receive. You may luckily receive a new bond in exchange that has a longer maturity and higher coupon. But many times, you get nothing," Offenberg says.
A recession may increase the number of defaults. In addition, how and when the Federal Reserve chooses to raise interest rates will also have an effect on high-yield bond prices.
"Prices will predict this event before it happens," Offenberg says. "Or prices can overshoot and present a buying opportunity. If you believe the Fed is likely to raise rates in a slow, gradual and gentle way, then high-yield bonds are presenting interesting opportunities for investment right now."
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