Last week we considered the current landscape for investment grade bonds, more specifically 10-year pieces of paper. While we discussed the fact that investment grade bonds provide relative capital safety for investors willing to hold to maturity, we also noted that the yields were certainly not eye-popping. In this day and age of low interest rates, investors wishing to achieve more robust returns need to invest in either longer maturity offerings or slide down the credit scale into high-yield bonds, otherwise affectionately known as “junk.”
To see a list of high yielding CDs go here.
However when one extends maturities with a higher interest rate environment potentially looming, there could be tremendous opportunity cost involved. And when one starts to sacrifice credit quality in the name of yield, capital could become in peril if the specific issuer runs into problems or the general economy begins to plunder. Thus careful consideration of the risks and rewards of high yield bond investing is advised.
As we noted last week, within the bond ratings world there are numerous delineators of investment quality. In the below chart, which any bond investor should become intimately familiar with, we see the various levels of junk, ranging from Ba1/BB+ all the way down to D, or in default.
Despite the rather offensive description, junk debt by all accounts currently does not pose a doomsday risk profile. Recent reports from Moody’s put the default rate at about 3 percent for the cumulative domestic high-yield universe. Compare that to the around 13% default rate back during the financial crisis of 2009.
In basic terms, the credit ratings agencies perceive a higher level of financial “stress” on a company, municipality or entity when the junk moniker is slapped on it. The agencies may feel that a “junk” company is simply over levered or that its revenue/earnings profile and balance sheet call into question its future ability to repay obligations. Ratings are both objective and subjective, taking into account what the company’s finances look like today, and what they may look like in the future, based on the current health and fundamental direction of the business.
And despite the fact that both are termed “junk,” there is a world of difference in an entity rated Ba1/BB+ versus one that is rated “in the Cs.” The BB+ entity is one small positive step from earning an investment grade rating, while any company with a C rating may be one small misstep from having to default on its debt. There’s also typically a world of difference in the yields between a BB+ rated company and a “C” company.
On a cursory search I was able to find BB+ secondary issues yielding anywhere between 4-8%, mostly depending on time to maturity. One can easily find double digit yields when dropping search criteria into the “C” realm. For example, I was able to find secondary, near-term (<4 years) pricing for distressed retailer JCPenney offering investors 10-12 percent yields. With the bankruptcy rumor mill starting to swirl, there appears to be a high level of short-term risk in loaning money to this company.
Though I’m not a proponent of bond funds in general, I think the junk space provides for one time when investors might be wise to consider a pooled product either via an ETF or perhaps a CEF (closed-end fund). Pooled products provide instant diversification and professional management for a fee. As I’ve written previously, I believe investors that comprehend the risks of CEFs can find tremendous value there in the current market. I think when one considers raising the risk bar, especially into the deepest depths of high-yield, a fund makes a lot of sense for most mainstream high-yield investors.
Others with a higher risk tolerance, keen understanding of credit analytics, or a greater asset base on which to diversify may certainly opt for individual issues. Today’s online research capabilities and ability to quickly buy and sell bond pieces has empowered the individual investor to build an individual portfolio of bonds and take a pass on the ongoing drain of management fees.
For most investors wishing to maintain a well diversified portfolio of bonds, but seeking to boost yield, I think a reasonable, but not crazy allocation to junk bonds is warranted. As we’ve noted, if one keeps credit quality at the “upper end” of high yield, i.e. BB rated issues, capital risk may be minimal. However, when we start looking at “C-stuff” like JCPenney, the risk/reward pendulum swings precipitously in the opposite direction. If you have some reason to believe that JCPenney will have blowout holiday sell-through, then by all means consider its debt. Just understand the consequences if you happen to be wrong.
My personal allocation to high-yield is rather minimal. I own several pieces of BB rated corporate paper, and three CEFs: Alliance Bernstein’s Global High-Yield (AWF), and two Western Asset Funds, High Yield Opportunities (HYI), and Emerging Markets Debt (ESD). I have the risk tolerance to be more aggressive, yet considering the uncertain economic times in which we live, I find it more prudent to err on the side of caution.
Junk debt is a broad term that encompasses a rather vast universe of fixed income securities. While there is a general heightening of risk when one considers and invests the space as opposed to investment grade credit, I believe investors can successfully manage that risk by considering personal tolerances, the breadth of both fund and individual offerings, and by continually monitoring the macroeconomic climate.
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