When the word “junk” comes to mind, what pops into my head is something worthless that adds no value. Agree? In the investment landscape there is a type of fixed-income investment (commonly known as bonds) called “junk bonds”. While not rated as high on the ladder in terms of quality and security in the bond spectrum, junk bonds are clearly not “junk” as a definition may imply. In fact, these investments can play an important and even essential role in your investment portfolio. I will contend that just because a bond is considered “junk” does not mean that an investor is throwing their money away.
To begin, what are junk bonds? Quick and easy, they are a special type of debt instrument issued by corporations that offer much higher yields than other bonds in the marketplace (junk bonds are synonymously referred to as “high-yield” bonds). As with other types of corporate bonds, an investor lends the corporation money with the intention of getting interest on a recurring basis and repayment of their initial principal down the road. The main difference with junk bonds is that with the higher yield they offer comes much higher risk of payment of interest and principal in the future.
These type of bonds are referred to as “junk” not because they are worthless and have no value, but because they are not rated as high by the bond rating services. Bond rating agencies, companies such as Fitch, Standard and Poors and Moody’s assign ratings to the variety of debt instruments issued by companies. Every bond in the world falls into one of two categories, either they are investment grade or non-investment grade.
Investment grade bonds have a rating of BBB or higher (all the way to AAA). By assigning these ratings, the rating agencies are saying that they believe, based upon the company’s current financial position, interest coverage ratio (the ability to pay the bond’s stated interest) and economic outlook, that the chance of the company going into default on its debt obligations is not substantial. These bond issues often have a history of long, uninterrupted interest payments to bondholders; the bond coupons keep flowing like clockwork.
Non-investment grade issues (aka junk bonds), on the other hand, are those that have been assigned a rating of BB or lower (all the way to D). These debt obligations possess a much higher risk of default or loss of principal. The companies that issue junk bonds must somehow entice investors to risk their money. In order to do this, they offer a much higher coupon rate than their investment counterparts. Ironically, this increases the inherent risk because the companies that are least able to afford high-interest charges pay double or triple their better-capitalized counterparts.
So given the much greater risk inherent in junk bonds, why would one consider adding them to their investment portfolio? There are two reasons why I believe holding a small percentage of junk bonds in an investment portfolio can help improve returns while lowering risk.
First would be the higher rate of interest that junk bonds offer. Under normal economic conditions, high-yield bonds generate returns that are 3% to 4% higher than the yields on Treasury bonds that have the same duration. This is particularly important in a low-interest rate marketplace where we are currently at today. Income investors, especially ones desiring more income in retirement, are often searching for yield anywhere. When incorporated in a portfolio of other interest-producing assets (such as U.S. Treasury securities, municipal bonds, highly-rated corporate bonds, municipal bonds, certificates of deposit and savings account) high-yield bonds can help investors get closer to their average need for yield.
The second reason why junk bonds should be part of your portfolio is the potential price appreciation that junk bonds offer. By design, high-yield bonds are less sensitive to changes in interest rates than they are to economic growth than other bonds (a measurement called “duration”). As such, even though they are bonds, they tend to act more like stocks, performing well when the economy and stock market are doing well, and performing poorly when the economy and stock market are declining. When economic growth is robust, or when a certain sector of the economy has been growing rapidly (like the energy area for the past couple years) junk bonds can have quite dramatic increases in prices. This correlation to stocks and low-to-negative correlation to Treasury bonds can positively affect diversification in an investment portfolio. As such, a small allocation to these high-yield bonds can help minimize risk through diversification.
As we have discussed, junk bonds do have much greater risk than other higher-rated corporate bonds. This can be seen when recessions comes around every few years, which can cause junk bonds to have disastrous returns. During the onslaught of the Great Recession in 2008, the average junk bond mutual fund tracked by fund rating firm Morningstar returned a debilitating -26.41% return. Particularly negative returns can be seen in the junk bond market because during tough economic times when weaker companies (who often issue junk bonds) are less able to pay their debts, default. This can cause junk bond prices to decline substantially. Furthermore, the junk bond market is in the early stages of facing a double “whammy”: higher interest rates and a “wall” of maturities. The Fed is expected to continue to gradually raise interest rates this year and next. Furthermore, it’s not very long before investors will start focusing on the combined $600 billion of junk bonds set to mature in 2018 and 2019, which could hit high yield debt prices.
Taking account of the benefits and drawbacks of investing in junk bonds, should these riskier fixed-income investments be part of your long-term investment portfolio? I contend yes. Depending on what stage of the economic cycle we are in and one’s appetite for risk, having 2% to 5% of your portfolio allocated to high-yield debt is reasonable exposure. The best way to get exposure to the junk bond market is through mutual funds or exchange traded funds. The iShares iBoxx USD High Yield Corporate Bond ETF (HYG), which has nearly $16 billion in assets, is one such product. It boasts a low expense fee of only 0.49%, is well diversified with over 1,000 bonds and actually has almost 10% of its portfolio devoted to CCC-rated debt. Investors have been well compensated with this product over the past 10 years with an average annual return of 6%.
Of course, it is always wise to speak with your financial advisor to see if these investments are suitable for you. Take a look at the short video attached for more information on junk bonds.