The floor of the New York Stock Exchange.
(photo credit: REUTERS)
Weak economic data in the US has triggered a global drop in markets. Stocks weren’t the only asset class that have gotten clobbered over the last month. High-yield bonds joined the party as well. For investors searching for income in today’s near-zero interest-rate environment, this sell-off may present an opportunity.
When I mention high-yield bonds to clients, the response I inevitably get is: “Are those like junk bonds, because if they are, I don’t want to have anything to do with junk bonds.”
For those of you either too young or who just don’t remember, junk bonds became a household name in the late 1980s as the US government went after “Junk Bond King” Michael Milken on insider-trading, fraud, racketeering, tax-evasion and various other charges. In 1990, Milken pleaded guilty to six counts of securities and tax violations. What Milken discovered was that distressed companies were valued less than what they were worth.
Speculative-grade bonds thus became ubiquitous in the 1980s as a financing mechanism in mergers and acquisitions. In a leveraged buyout (LBO), an acquirer would issue speculative-grade bonds to help pay for an acquisition and then use the target’s cash flow to help pay the debt over time.
While I personally think Milken is one of the most important financial figures of the last 50 years, and think he got a raw deal, I am not going to use this space to defend him. I’ll save that for another column. To understand his contribution to the global economic growth of the last 30 years, it’s important to read what well-known economist and lover of the Israeli hi-tech miracle George Gilder wrote in Telecosm: “Milken was a key source of the organizational changes that have impelled economic growth over the last 20 years. Most striking was the productivity surge in capital, as Milken… and others took the vast sums trapped in old-line businesses and put them back into the markets.”What are high yield bonds?
Enough about the history and scandal behind this asset. Let’s look at what high-yield, or junk, bonds actually are. A high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade. These bonds have a higher risk of default or other adverse credit events, but they typically pay higher yields than better-quality bonds to make them attractive to investors.
While there is risk with junk bonds, it depends on how “junky” one decides to go. If an investor sticks to “quality” higher-rated junk, the risk of default goes down considerably. This is very important in light of where we are currently in the business cycle. According to Gershon Distenfeld, director of high-yield debt at AllianceBernsteind: “Our biggest concern: the lowest- rated credits. CCC-rated bonds have recently begun to underperform, but these are the most fragile companies with the most leverage. It doesn’t take much for these companies to fail – they often do so even before the broader market starts to see real deterioration.”
What about yield?
And what do you get for the added risk? Well the yield on the SPDR Barclays Capital High Yield Bond ETF is currently 5.8 percent. Not to shabby. While this is still historically low, yields have risen recently, providing an intriguing entry point for income-seeking investors. For investors who are looking for less potential volatility in the high-yield market, the SPDR Barclays Short Term High Yield Bond ETF is currently yielding 5.2%.
What are the risks
Andrew Sachais wrote in SeekingAlpha: “US economic data is clearly still on the path to recovery, but with the Fed ending its stimulus program, it seems more evident that the US will have to weather the storm with less support. This realization is leading investors to sell off riskier assets with a voracious conviction for the first time in many years, resulting in large declines in both equity markets and high-yielding corporate debt.”
Investors should speak with their financial professional to see whether high-yield bonds have a place in their portfolio.The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc., or its firstname.lastname@example.org
Aaron Katsman is a licensed financial professional in Israel and the United States who helps people with US investment accounts. He is the author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.