Junk bonds don’t belong in long-term portfolios

I recently met a woman who came to me for advice on her existing portfolio. She had been investing for a while, but feared that her portfolio might weather another market downturn. As she was close to retirement, she wanted to be reassured that her investments were being spread out prudently.

One of the first things she mentioned was that she didn’t like junk bonds and wouldn’t have them in her portfolio. Scrolling through her list of investments, I was shocked to discover that she had not just one high yield bond fund, but three! Such is the nature of junk bond funds: they can be very difficult to spot.

High yield bond funds are typically marketed to individual investors using nice names to suggest they are less risky than they really are. But don’t lose sight of the fact that “high yield” is a euphemism for “trash.”

Funds with names like Opportunity and income Where Income benefit are intended to inspire confidence even though the wording of the prospectus may state that “junk bonds…involve a higher risk of default”.

With greater reward comes greater risk

According to Bloomberg, January 2019 was the best month for high-yield bond sales since at least September 2018. Funds that bought these bonds also had a strong month, reversing most of the losses they suffered l ‘last year. It seems that investors’ appetite for high yield bond funds is still strong. But do these funds make sense in a diversified portfolio?

Junk bonds are the corporate debt equivalent of a subprime mortgage, as they are considered below “investment grade” by debt rating agencies like Standard & Poor’s and Moody’s. Companies that have weak balance sheets, pay bills slowly, or have defaulted on past obligations would be the worst examples of junk bond issuers. Companies with highly cyclical, capital-intensive, or low-profit-margin businesses are more typical issuers of “high-yield” debt.

Due to the greater risk of default, investors require companies that sell junk bonds to pay higher interest rates than more stable companies. Interest rates on junk bonds are determined in much the same way as interest rates on consumer loans. The lower a person’s credit score; the higher the interest rate they will pay on their debt. It’s the same with corporate borrowers. In each case, the lender must be compensated for taking an additional risk. And that’s the whole point here. Investors who hold high-risk bond funds accept additional risk not present in higher-quality fixed-income products.

Junk bond risk in the context of yield

All investments involve risk, but investors can reduce it by diversifying their holdings across different asset classes (i.e. using strategic asset allocation). The factors that go into the asset allocation decision are unique to the specific individual investor. But, ultimately, the portfolio that emerges should provide that investor with the highest expected return with the lowest possible risk. Interestingly, the theory behind this approach is based on a portfolio that includes only government bonds, which are generally classified as a risk-free asset.

If a portfolio is designed to achieve specific future results, constructed on the principles of generally accepted investment best practice, and if it can deliver the expected return needed to achieve those results, then why would that same investor deliberately inject more risk in the mix than necessary?

Junk bond risk in the context of treasury bills

Currently, the spread (difference) between junk bond yields and US Treasury yields is about 4 percentage points. That’s a pretty big gap in the current interest rate environment. But consider this spread in the context of the risk that junk bonds present relative to government bonds.

Treasury Bonds are guaranteed by the full faith and credit of the United States of America. The risk of default on them is as close to zero as it gets. The same cannot be said for junk bond issuers.

All investments involve risk. Even treasury bills have inflation risk and interest rate risk. But both of these risks can be mitigated by using portfolio management techniques such as laddering. This might be a little harder to do with junk bond funds, especially if fund flows remain as negative in 2019 as they did in 2018. Large outflows can affect fund and EFT redemptions and pricing. These risks are completely absent from Treasuries.

Consider the possibility that the US economy will at some point in the future experience a slowdown or recession. None of these circumstances is likely to affect the ability of the federal government to meet its obligations to bondholders. Of course, the same cannot be said for junk bond issuers.

What it means and what investors should do

For investors looking to generate income and reduce portfolio volatility, bonds are a great fit. However, seeking yield by using lower than higher quality bond funds may not be the most prudent way to achieve these goals.

Concretely, how can an individual investor determine which bonds he owns and whether they are appropriate? First, research the funds and ETFs you own. Many websites (Yahoo Finance, for example) will provide information about the underlying holdings and the quality of the bonds in the fund you own. Remember that investment grade bonds or investment grade bonds are rated A or better. If the majority of the fund’s bonds are rated B or lower, it is a high-risk bond fund. Also check the performance. If it’s 4 percentage points or more than a treasury, it’s probably a junk bond.

Also, look for the term “high yield” in fund literature. You generally won’t see fund companies using the term “junk bonds” or advertising the higher risk factor. High yield seems to be a desirable trait. Unfortunately, many investors don’t realize that a high yield bond fund holds risky positions, and those higher yields can add additional volatility. If your goal is to add stability to your investments, you better focus on quality first.

Investment Advisor Representative, Better Money Decisions

I’m CEO of Better Money Decisions (B$D) and co-author of the Better Financial Decisions blog. As Director of B$D, I am excited to continue my long career as an investment professional. Living and working in places as diverse as Saudi Arabia and Budapest, Hungary has given me a unique perspective on the investment world. My book, “Bozos, Monsters and Whiz-Bangs: Bad Advice from Financial Advisors and How to Avoid It!” is an insider’s guide to finding the right advisor.

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