Many bond investors today favor the relative safety of investment grade bonds like United States Treasurys. But interest rates on all higher quality bonds have been gradually deteriorating for many years. In 2011, they’re at all time lows, making it very difficult to put together a good fixed income portfolio for retirement. Now might be a good time to reconsider high yield bonds, because it’s one of the only areas that has good interest rates in today’s markets.
As a fixed income investor, you’ve got a wide range of possible options. First, you could purchase high grade bonds, often from governments. Second, you could buy AAA or similar corporate debt. Doing this would be still relatively safe. As a matter of fact, some corporations are currently paying lower interest than many government bonds. Finally, you can invest some of your money in high yield bonds.
Buying individual high yield bonds is not a practical approach for most individual investors. The bond market is dominated by professionals, who spend their days investigating corporate financials and assembling portfolios with maximum returns and the least amount of risk. Luckily for you and me, there are many good high yield bond funds and ETFs on the market. They are managed by professional portfolio managers who work hard to not lose money on the bonds they choose, and provide the great benefit of diversification. For instance, the two most widely used high yield bond ETFs (with ticker symbols JNK and HYG) currently hold 223 and 446 different bonds within their fund respectively. Likewise for many of the available high yield bond mutual funds: they hold a large selection of individual securities, controlling some of the impact of default and price declines. You can go to Morningstar, Yahoo Finance or other popular investment websites and easily find good high yield mutual funds.
You have to be a little mindful about when to invest in speculative-grade debt. One approach is to track the so-called interest “spread” between high yield and high grade securities. High yield bonds often yield between four and 6 percent more than bonds that are considered less risky. A higher spread signals a greater risk of a slowing economy. During economic recessions, this spread rises, as investors flee to the safety of government and other less risky bonds. High yield issuers then must pay generous interest rates to get investors to buy their bonds, so the interest rate difference may be six percent or more. This is frequently the best time to buy high yield bonds. For example, during the global financial meltdown in 2008 and 2009, the high yield spread increased to more than 7% over United States Treasurys. And high yield bonds have gained a lot in value since that time.
It’s also advisable to know that high yield bond prices typically decline during economic recessions. So in a way, they behave somewhat like stocks. This means potential investment losses.
High yield securities are often referred to as “junk bonds,” and often portrayed in a negative light. Don’t let this term fool you and dismiss them out of hand. You owe it to yourself to seriously consider them as a potentially valuable source of high current income for your investment portfolio. But do bear in mind that high yield bonds are a lot riskier than many higher grade fixed income securities. There’s no free lunch: with the added yield comes increased risk.
