High Yield BondsBond Instruments
The credit ratings scale for firms starts at AAA, and descends down to debts already in default. High yield bonds are below the rating BBB or BAA. These debts are typically referred to as junk bonds, representing their high likeliness for defaulting. The polite “High Yield” name refers to their increased returns to compensate investors for taking on the risk of owning them. The lower the rating, the more compensation you should expect for the risk you are adopting.
The risk these bonds pose as an investment should not be underestimated. Typically, bonds will increase portfolio stability, or provide reliable income. They may be used to preserve liquidity in the extremely short term. Bonds that are highly likely to default can’t reasonably serve these purposes. Making matters worse, these bonds are sold by firms which are already in shaky situations. A downturn in the economy can sink many of these firms entirely. If the firm sinks, both equity and bond owners lose their investment. However, bondholders will receive minor reimbursement for their loan. It will not be anywhere near the investment they made. You are entering bonds to reduce your risk, not suffer the same risks as shareholders at the same time.
Ultimately, many high yield bonds are only slightly less risky than equities in those same firms. This means there won’t be any real diversification between the shares and the bonds from those firms. The firm goes bust, you lose your bond, get a tiny percentage as payment. The firm goes bust and shareholders lose their investment and receive no payment. Both of you lose, one simply loses slightly more than the other. With investment grade corporates, the shares will nosedive but the firm will not usually enter bankruptcy or default. They will continue to send payments for their bonds, and it will be reimbursed at maturity or call.
There are other problems. If the credit rating of the bond is increased and the bond is callable, the firm will call the bond at their first opportunity. This is the intelligent move for them. They can reissue new bonds at the higher credit rating with less interest expense as compensation for reduced risk. While high payouts relative to reduced risks are desirable, chances are you won’t have the bond after the risk reduction is recognized market wide.
High yield bonds can also suffer trading liquidity issues. Most people in the bond market do not want them. They especially don’t want to own them when you will need to get rid of them quickly. Since bonds at lower credit ratings run high risks of defaulting once they are issued only a small percentage of people want to own them. If your firm is potentially going to go bust, no one will want to buy into your position unless you are going to cut them the world’s sweetest deal. Expect trade liquidity problems if a high yield issuer has an economic downturn.
You would hope the higher yields from these bonds would reduce concerns about inflation rates, but if so you are forgetting: Periods of higher inflation usually damages the businesses that issue these bonds, and increase the likelihood that they will eventually default. This increased pressure results in higher amounts of lost income. If the firm survives it may exceed the inflation rate, but if it doesn’t you have only dealt your portfolio increased damage.
All of these problems mean one thing. If you are going to play with junk bonds, you need a very wide array of them. Due to their tendency to collapse with shares instead of staying afloat you do not want to substitute them for government or corporate bonds. You only want to add high yield bonds in addition to your regular bond collection, and not if you own shares from the same firm or many risky firms. Most importantly, you should never waste space in retirement accounts by placing high yield bonds in them. They’re too likely to default and waste the allocated space.
Since wide diversification is required, it would be wise to purchase them through a bond fund and never directly. This way, you buy into several hundred varieties of high yields with a single 1,000 units of currency instead of purchasing one defaulting bond with that money. It’s also wise to purchase them outside of your own domestic market. A foreign junk bond fund will significantly assist you, but be aware of economic situations in that specific foreign market before you buy into the bond fund. Also ensure that market is not a source of most of your equity investments.
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