In an article I wrote earlier this month, I examined portfolio construction and some of the different assets I use to create a diversified stream of income. In today’s article, I’m looking at high yield bonds (sometimes called junk bonds), which are an asset class I use to boost the yield of my portfolio above the returns generated by the broader market.
What are High Yield Bonds?
These bonds are usually issued by companies with a lower than investment-grade credit rating. A company’s credit rating is determined by similar things to an individual – how much debt they have, their cashflows, what assets they have to offer as collateral etc.
The better a company’s credit rating, the less likely they are to default on their debt. By contrast, high yield bonds are issued by companies with less solid finances and balance sheets; they generally have higher levels of debt, unproven business models, or even negative earnings, making it less likely that they will be able to make interest and principal payments on time.
Because of this, these companies have lower credit ratings and consequently have to pay more to lenders to borrow money.
The Risks of High-Yield Bonds
As someone who invests in high yield through an exchange-traded fund (rather than purchasing individual bonds), the risk of default isn’t really my primary concern as the historic annual default rate for high yield bonds is about 4% a year.
Instead of this, I’m more concerned by the volatility levels of high yield bonds compared to other income-produced assets I own.
My high yield bonds have performed well over their lifetime, but I’ve noticed extremely rapid drops in their when the market environment takes a negative turn.
Why do I invest in High Yield Bonds?
I generally use high yield bonds as a middle ground between stocks and bonds in my portfolio. While they are fixed-income assets, I’ve found them to have higher volatility than most segments of the bond market, but also a closer correlation to the stock market returns than investment grade bonds.
As someone looking primarily for income-producing assets, high yield bonds are therefore a great fit for my portfolio.
The risks of investing in High Yield Bonds
High yield bonds also have their disadvantages, and higher volatility and default risk are not things I tend to ignore.
Another pitfall to investing in high yield bonds is that a poor economy and rising interest rates can worsen yields. If you’ve ever invested in bonds before, you’ll be well aware that as interest rates go up, bond values fall. Considering interest rates are currently at all time lows, there’s only one way they can go from here, and that’s up!
I’ve also noticed that during the recent stock market rise, my investments in high yield bonds have failed to keep pace with my pure equity positions, depressing the overall return of my portfolio.
As with any investment, by sure of the risks before you put money on the table. Get some professional advice, and be sure of your goals. For me, high yield bonds have been a solid performer, adding attractive levels of income to boost my overall portfolio yield.