High-yield timing not easy
NEW YORK – You may be looking for better returns in the bond portion of your portfolio, but experts say you should be careful before pouring too many assets into high-yield funds.
On Wall Street, high-yield is the polite term for junk bonds – non-investment grade bonds with low credit ratings and, traditionally, a higher chance of default. The reason you win a more attractive yield on these investments is because there’s so much risk involved.
But with the economy humming along at a steady clip for the last few years, the risk associated with high-yield bonds has diminished. In fact, the default rate is currently just 1 percent, compared to a historical average of 4 percent to 5 percent.
It hasn’t always been that way. Just a few years ago, as low-rated telecom and tech companies went belly up after the bubble burst, junk bond default rates soared as high as 10 percent. You were probably too depressed to notice, but 2001 would’ve been a great time to invest in high-yield bonds.
“As is true of so many things in investing, the best time to do it is when it feels least comfortable,” said Don Cassidy, senior research analyst at fund tracker Lipper Inc. “And that means the best time to have done it was back when there was some blood in the streets. Now we are four years into the cycle and the timing is not so good.”
While quality bonds, such as highly rated corporates or government Treasuries, are driven by the interest rate cycle, high-yield bonds are far more dependent on what’s happening at the company level, and therefore more vulnerable to economic downturns. They are like stocks in this way, and can be just as volatile.
To evaluate the market for junk, sophisticated investors look at the difference between the yield of lower quality bonds and that of U.S. Treasuries. This “yield spread” is determined by default rates, economic conditions and investor expectations. With junk yielding about 8 percent and the 10-year Treasury note yielding about 4 percent, the spread is about 4 percentage points. That’s low compared to a historical average of about 5 percentage points, but higher than the 2.5 percent spread earlier this year.
The perception of low risk due to the low rate of default on junk bonds, combined with low yields on quality fixed income, has helped keep the spread narrow. But the spread may soon start to widen.
With spreads where they are, investors are not being as well-compensated as they once were for taking on more credit risk, Cassidy and other analysts said. For comparison, look back to the worst period of the last recession, when the difference between yields paid by low quality and high quality bonds widened to a 10-point spread.
Credit cycles typically last three to four years. So the fact that so many investors are reaching for yield in this area now is worrisome, said Michael W. Boone, a money manager in Bellevue, Wash. It suggests they are not aware of the risks.
“People are climbing the credit ladder,” Boone said. “They might say, ‘I’ve always been afraid of high yield bond funds, but they look like they’re doing well, I might as well give them a try.’ And when do they do that? After a three- or four-year run. I’m not saying they’re going to turn around and go negative right away. But I do think a lot of people are taking on a lot more risk than they realize in the high-yield market. …
“Don’t you dare try to go out and be smarter than the best portfolio managers out there and judge the credit quality of a company. That’s a really bad idea.”