High-yield bonds are commonly referred to as “junk bonds,” but when it comes to the benefits this asset class provides, investors should not be too quick to discard them when building portfolios.
High-yield bonds are rated below-investment-grade and offer higher yields than their investment-grade counterparts. They provide investors the opportunity to achieve healthy long-term returns similar to equities, but with less volatility. Historically, high-yield bonds have low correlations to other fixed-income securities, making them ideal for diversifying a fixed-income portfolio. In addition, since bondholders are given priority over shareholders in the event of a company's liquidation or bankruptcy, high-yield bond investors have a better chance of recouping their principal than equity investors. In fact, 97 to 98 percent of so-called "junk" pays off in full at maturity.
Recent market concerns about an increase in currently low interest rates should not sour investors on high-yield bonds. This asset class has traditionally been less sensitive to interest-rate risk and performed well during past periods of rising interest rates. Although high-yield bonds are sensitive to macroeconomic and corporate issuer developments, this characteristic can pay off handsomely for investors.
After rating agencies downgrade bonds to below-investment-grade status, risk-averse institutional investors will sell them at any price to remove them from their portfolios. This creates opportunities for investors who purchase those discarded bonds, since high-yield bonds are often called in or refinanced at lower rates prior to maturity. Furthermore, if the issuer's performance or credit rating improves, high-yield bonds that institutional investors didn't want can suddenly become valuable.
High-yield bonds offer many rewards, but the best way for investors to reap those rewards is through direct ownership. Many mutual funds and exchange-traded funds offer strategies that focus on high-yield bond investments, but the fees associated with these vehicles make direct ownership a more cost-efficient path. Plus, high yield bonds mature and mutual funds and ETFs do not, meaning funds have more of a principal risk.
Investors seeking diversification, steady streams of income and potential capital appreciation should consider adding high-yield bonds to their portfolios. While the asset class involves some risk, the long-term benefits outweigh any investor misgivings.
Don Stockhausen is an advisor at Palm Desert, Calif.-based HighTower Palm Desert and is based in Brookfield.