What about High-Yield Bonds? - dummies

By Russell Wild

No definitive line exists between investment-grade and high-yield bonds, sometimes known as junk bonds. But generally, if a bond receives a rating less than a Baa from Moody’s or a BBB from Standard & Poor’s, the market considers it high-yield.

High-yield bonds offer greater excitement for the masses. The old adage that risk equals return is clear as day in the world of bonds. High-yield bonds offer greater yield than investment-grade bonds, and they are more volatile.

But they are also one other thing: much more correlated to the stock market. In fact, Treasuries and investment-grade corporate bonds generally aren’t correlated to the stock market at all. So if bonds are going to serve as ballast for our portfolios, which is what they do best, why would anyone want high-yield bonds?

Many people misunderstand them, and if they understood them better, they probably wouldn’t invest. They certainly would not opt to give high-yield bonds a major allocation on the fixed-income side of the portfolio.

Invest in stocks in the good times

If the economy is strong, then companies are making money, the public is optimistic, and stocks are going to sail. So may high-yield bonds, but stocks historically return much more than high-yield bonds.

In general, a basket of high-yield bonds may return a percentage point or two or three more than high quality corporate bonds but very rarely more than that. Stocks have a century-old track record of returning about five percentage points more than high quality bonds. And, unless you have those bonds in a retirement account, you’re going to pay income tax on the interest.

Most of the gain in your stocks won’t be taxed at all until you sell the stock. Even then, it will most likely be taxed as long-term capital gains — 15 percent — which is probably lower than your income tax.

If good times are coming, stocks are very likely going to do better than any kind of fixed income.

Invest in bonds in the bad times

If the economy starts to sour and companies start closing their doors, then stocks will fall and high-yield bonds very likely will too. In 2000, for example, when the stock market started to crumble, a basket of high-yield bonds would have lost between 3 and 4 percent.

And in 2008, when stocks took an even more precipitous drop . . . yup, high-yield bonds went right down with them, harder than ever. Most junk bonds lost 20 to 25 percent of their value. The last thing you want is for your bonds to turn south right along with your stocks.

Invest in high-yield bonds judiciously

Many professional advisors are not a big fan of high-yield bonds. For most people, they don’t suggest a very large allocation, if any at all.

For people who really want junk bonds in their portfolios, take a serious look at foreign high-yield bonds, especially the bonds of emerging-market nations, which can make a lot of sense. That’s because they don’t have much, if any, correlation to the ups and downs on Wall Street.

In some cases, you may add domestic high-yield bonds to a portfolio as a means of reducing risk. But rather than substituting high-yield bonds for investment-grade bonds, substitute the high-yield bonds for stocks. Less potential return. Less potential loss.

High-yield bonds are a sort of hybrid equity/fixed income. But generally this strategy is good only if you can place the high-yields in a tax-advantaged account, such as an IRA.

Whenever you invest in riskier securities, the importance of diversification becomes magnified. Investing in individual junk bonds, unless you’re very wealthy and can spread the risk among many junk bonds, is not something you should ever do. Some very good high-yield bond funds are available, and it’s best to choose one of those.

If you’re wealthy (or not-so-wealthy but you choose to ignore good advice and invest in individual high-yields anyway), know that the broker markups can sometimes kill you.