High-yield bonds, also known as junk bonds, are corporate or government debt securities that analysts believe are likely to default. Junk bonds are suitable for investors comfortable with high risk. For retail investors these securities can play an important role in their portfolio, provided the risk is understood. Here’s what you should know.
How Junk Bonds Work
All bonds are essentially IOUs that offer investors periodic interest payments known as yield. A bond’s yield moves in the opposite direction of its price. When demand for bonds is high, the price rises and its yield falls. How high or low that yield depends on the financial security or credit worthiness of the issuer, whether it be a public or private entity. A low yield signals a strong credit rating for the bond issuer, which as a result doesn’t have to offer much yield to get investors to buy; a high yield signals a weak credit rating for the issuer, which must therefore offer a higher yield to attract investors.
Though there are many levels of bond ratings, all bonds can be grouped into one of two categories: investment grade and junk. Credit ratings agencies like Standard & Poor’s, Moody’s and Fitch issue credit ratings on bonds. Bonds with a credit rating of no more than BB (as issued by Fitch or Standard & Poor’s) or Ba (as issued by Moody’s) are called junk bonds. Bonds with a credit rating of at least BBB (as issued by Fitch or Standard & Poor’s) of Baa3 (as issued by Moody’s) are called investment grade bonds.
Junk Bond Default Rates
A bond is in default when the issuer fails to make a regularly scheduled payment or fails to pay investors back the principal when the bond matures. According to Standard & Poor’s, junk bond default rates range from approximately 18% for BB-rated securities to more than 50% for CCC/C-rated bonds. This represents data over a range from 1981 – 2018. More recently, the annual average default per rating for a range spanning 2014 – 2018 was:
- Rating BB – 0.14%
- Rating B – 1.78%
- Rating CCC/C – 26.22%
Published default rates for junk bonds often vary widely. That’s because the term “junk bond” encompasses a wide range of risky bonds. When analysts refer to a junk bond, they could be talking about anything from an asset that just barely missed investment-grade (a BB or Ba rating) all the way to one currently in default (a D or C rating). The upshot of that disparity accounts for the wide range of published default rates.
Junk Bond Return Rates
One of the things that can make junk bonds a potentially useful asset for diversifying your portfolio is that a bond’s price, a key component of rate of return, moves counter-cyclically with the economy.
When the economy is strong, the rates of returns on junk bonds are often low. That’s because during such times investors tend to sell bonds and buy stocks. That lowers the price of bonds.
For example, as the fall of 2019 came to an end, junk bonds were posting an average yield of 5.75%, as measured by the Merrill Lynch US High Yield Master II Index, a common benchmark. This relatively modest return reflected the strong underlying economy.
A strong economy can also lower default rates because bond issuers are operating in a more benign environment. In 2018, bonds, except those already in default, had a default rate that ranged from less than 1% to 0%.
On the other hand, when the economy is weak the rates of returns on junk bonds often rise. That’s because their yield, another key component of rate of return, soars. During the Great Recession, which began in December 2007 and ended in June 2009, junk bond yields shot up: In December 2008 the average yield peaked at a lofty 23.26%. This offered investors a full quarter on the dollar … if they could stomach the market in a year when even AA bonds began defaulting on their loans.
As with default rates, return rates on junk bonds vary by the issuer’s credit worthiness. At the time of writing, for example, AA-rated bonds had a 2.310% average yield over a one-year period. In that same time CCC-rated bonds offered 12.699%. As always, investors willing to roll the dice can make much more.
How To Invest In Junk Bonds
For a retail investor, the best way to invest in junk bonds is the same as it is for investment-grade assets, seek mutual funds or ETFs built around high-yield bonds.
This works for two main reasons. First, it eliminates complexity. Very few individual investors have the resources to buy corporate bonds on the primary market, which means purchasing them directly from the issuing corporation. This requires that you buy millions of dollars’ worth of bonds at a time. While the secondary market is a viable option, it is also one which requires a high degree of expertise and often resources to use effectively. Investing in bonds through funds allows you to expand your portfolio into this asset class without assuming the risk that might come from ignorance.
Second, buying bonds through mutual funds and ETFs allows you to spread your risk over multiple assets. In the junk bond market this is especially important. Given the relatively high rate of default among holdings in junk bonds, a bundled portfolio can allow you to capture their returns without the exposure that comes from holding a limited number of such assets.
Do your research before investing. Pay particular attention to these four factors:
- Volatility – This is a highly volatile asset class. How well has this fund managed price fluctuations, and does it align with your time frame for investing? If the fund is highly volatile but generally trends upwards, you will want to make sure you can hold your investment for several years in order to make sure you capture its gains.
- Average Returns – How well has this fund paid off? Junk bonds are generally seen as the middle ground between equities and investment-grade bonds, more secure than a stock but more profitable than a AAA debt asset. Make sure your fund can actually meet your expectations for a return before investing.
- Losses – Junk bonds default. This defines the asset class. Before investing in a fund, look at how often it has posted losses. This will tell you a lot about how well the fund can select high-yield bonds that actually pay off, and how well it avoids the ones that go bust.
- Caa/CCC Composition – Related to losses, how many bonds does the fund hold that are near or in default? The difference in nonpayment between B-category bonds and C-category bonds is substantial. Once you get into the C-category assets, you run a very real risk of losing your entire investment.
For the retail investor with a strong risk appetite, allocating some assets to high-yield or junk bonds may be a prudent move, boosting the overall returns on your portfolio without equity volatility. For one thing they offer higher yields than investment-grade bonds. It helps protect a portfolio’s value when the economy is weakening. In addition, junk bonds are not highly correlated to other types of bonds.
- If you’re not sure how to find a fund or ETF that focuses on high-yield bonds, a financial advisor may be able to help. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Do your homework. Assess where in the business cycle the economy is. Junk bonds are vulnerable to interest rate increases. That could happen, for example, when the Federal Reserve raises rates to keep the economy from overheating.
Photo credit: ©iStock.com/tupungato, ©iStock.com/designer491, ©iStock.com/TK