During the late 1980s and 1990s, high yield bonds evoked thoughts of investment scandals and unscrupulous financiers like Michael Milken and Ivan Boesky, who ended up being depicted in newspapers and on TV as “junk bond kings.” Today, many investors still opt for the relative safety of investment grade bonds like U.S. Treasurys. But interest rates on all high grade bonds have been steadily deteriorating for many years. This year, they’ve reached record lows, which makes it very difficult to set up a good fixed income portfolio for retirement. Now might be a good time to take another look at high yield bonds, because it’s one of the few areas that offers good interest rates in today’s markets.
As a fixed income investor, you've got a wide range of possible options. First, you could invest in high quality bonds, often issued by federal or state governments. Second, you could buy high grade corporate debt. This is reasonably safe. In fact, some corporations are now actually paying lower interest rates than many sovereign (government) bonds. Finally, you could commit some of your capital to high yield bonds.
Purchasing individual high yield securities is beyond the reach of the majority of individual investors. The bond market is dominated by institutional players, who spend their days studying corporate financials and assembling portfolios of the highest possible returns and minimum volatility. Luckily, there are lots of good high yield bond funds and ETFs that you can invest in. These are managed by professional portfolio managers, and provide the necessary 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 in their fund portfolio respectively. The same is true for a lot of of the available high yield bond mutual funds: they hold hundreds of individual securities, managing some of the adverse impact of default and price declines. You can visit Morningstar, Yahoo Finance or any other major investment websites and easily find good high yield mutual funds.
You need to be somewhat mindful about when to invest in high yield. One approach is to keep an eye on the so-called interest “spread” between high-yield and high-grade securities. High yield bonds usually yield between four and six percent more than safer bonds. During an economic crisis, this spread rises, as investors flee to the safety of government as well as other less risky bonds. High yield issuers then have to pay a high interest rate to get investors to buy their bonds, so the interest rate difference may be 6% or sometimes even higher. This is often a good time to purchase high yield funds. For instance, during the global financial crisis in 2008 and 2009, the high yield spread rose to more than 7% over U.S. Treasuries. And high yield bonds have appreciated considerably since that time.
You should also be aware of the fact that high yield bond prices frequently go down during economic recessions. So in a way, they behave like the stock market. This means potential investment losses.
Don’t let the bad reputation of high yield bonds prevent you from considering them as a valuable source of income for your investment portfolio. But also be aware that high yield issues are a lot riskier than many higher grade fixed income securities. With the added yield comes increased risk — there’s no free lunch.