People always love inadvertent contradictions, such as "civil war," "original copy" and "working journalist." Here's a new contradiction to the list: "high-yield bond."
Currently, high-yield bonds – IOUs issued by companies with dubious credit ratings – yield about 5%, which isn't high by anyone's standards, including those who manage high-yield bond funds. If you're thinking of reaching for a bit more yield through a high-yield bond fund, you might want to check again.
"Don't reach for yield" is one of those time-honored Wall Street phrases, like "Don't catch a falling knife" and "Don't smoke in a fireworks factory." It means that taking the highest-yielding option can often be harmful to your wealth.
The reason: No one offers to pay a high yield voluntarily. You wouldn't call your credit card company and say, "Frankly, you're taking on a lot of risk lending money to a deadbeat like me. If I were you, I'd charge me 30% a year to compensate for the risk that I'll totally stiff you."
The same is true with corporate borrowers. They pay high interest rates on their bonds only when they have to, which is why high-yield bonds are called junk bonds. And the lower the credit rating, the higher the interest rates these companies pay.
But "high" doesn't mean much in these low-rate days. The average high-yield bond yields 5.04%. "At 5%, it's tough to call it high yield," says Elaine Stokes, co-portfolio manager of the Loomis Sayles Bond Fund.
To put bond yields in perspective, traders typically look at the difference in yield between junk bonds and comparable Treasury securities. By that measure, too, yields are low – 3.46 percentage points above Treasuries, says John Lonski, team managing director of the economic group at Moody's Analytics. The median spread – half higher, half lower – is 4.18 percentage points.
The only time the spread was was lower: June 2007, which was an exceptionally bad time to buy high-yield bonds. There was a little thing called the worst financial meltdown since the Great Depression shortly afterwards.
Yields on high-yield bonds soared, because bonds with shaky credit ratings looked as appetizing as the dollar menu at a greasy spoon in the Great Meltdown. Sellers had slash prices to get rid of high-yield bonds. The spread between high-yield bonds and Treasuries zoomed to more than 20 percentage points, and high-yield bond funds got clobbered, clocking an average 30% loss in the 12 months ended from November 2008.
In those days, the brave could have made a fortune scooping up bonds that yielded 20% or more. But now that yields have fallen again, being a high-yield bond manager is like being a bargain-hunter at Prada. "It's challenging," Stokes says, particularly when investors are so desperate for yield. Making things worse: "In any market so ripe with cash chasing bonds, the quality of loans is going to go down," she says.
What that means: The shakier the borrowers, the more likely it is that they will default, leaving bondholders to stand in line in bankruptcy court. Moody's expects the high-yield default rate to rise to 2.7% by March 2015, up from 1.7% in March of this year, in part because new bond issues have been of lower quality than previously. Combine that with the prospect of rising interest rates – poison for bond prices – and you have a singularly unappealing outlook for high-yield bonds.
Stokes has been adding convertible bonds and even high-yielding stocks to her portfolio. "We're finding fewer and fewer real interesting opportunities in high yield," she says. "We've added some high-dividend equities to the portfolio. You can get a 3% to 4% dividend yield in equity you like." And, she said, some convertible bonds offer decent yields and exposure to areas the managers like, such as health care.
Investors should look for funds that hold higher-class trash. You'll get slightly lower yields, but you'll also get somewhat better protection if the economy hits an air pocket. Todd Rosenbluth, senior director at Standard & Poor's Capital IQ, points to the two largest junk-bond exchange-traded funds as a study in contrasts.
• SPDR Barclay's High-Yield Bond (ticker: JNK), has nearly 700 holdings, according to Morningstar, and about 61% of its holdings are rated B or below.
• iShares iBoxx $ High Yield Corporate Bond (HYG), has 915 holdings and 44% are rated B or below.
For cautious investors, the iShares offering has more holdings, and is therefore more diversified, and fewer low-quality bonds. Predictably, it's the lower-yielding of the two, yielding 4.41% vs. 4.78% for the SPDR offering.
Even more cautious investors might consider SPDR BarCap ST High Yield Bond ETF (SJNK), which invests in high-yield bonds that mature in three years or so. The fund yields 3.82%, but it should suffer less than other funds when interest rates rise. Junk bonds are less susceptible to rising interest rates than most other bond funds, but they're still bond funds, and when interest rates rise, bond prices fall.
High-yield bonds have served investors well the past five years, gaining an average 13.4% a year, according to Morningstar. And this year, they have gained 3.5%, which is more than you would have gotten from the S&P 500 with dividends reinvested. Not surprisingly, investors have poured more than $41 billion into the funds the past five years.
But reaching for yield at this point in the interest rate and credit cycles is a high-risk activity, and no less a person than Janet Yellen, chair of the Federal Reserve, warned on Wednesday about taking too much risk to get a bit more yield. You should generally sit up and take notice when the Fed chair warns about anything. If you've made a lot of money in high-yield bonds, perhaps it's time to say thanks and take some chips off the table. If you're thinking about investing in high-yield bonds, you should wait until bond yields are, in fact, high.