High yield bonds

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High-yield bonds, also known as Junk bonds, are bonds that carry a low credit rating.[1] They are generally off limits for institutional investors because of their higher risk of default. Hence they are also known as non-investment grade bonds. Non-investment grade bonds are rated[2] BB or lower (D means default); investment-grade bonds are BBB or higher, with AAAs at top, a status that government bonds in developed countries strive to attain or maintain.

They were infamously promoted as an asset class by Michael Milken[3] of Drexel Burnam Lambert [4] in the 1980s as a means to finance leveraged buyouts. Milken was later jailed on charges of insider trading; and Drexel later failed, after posting its first losses in its history.

Canadian bonds are generally rated by two bond rating agencies: DBRS and Standard and Poor's, which bought the Canadian Bond Rating Service in 2000.

Risks

High-yield bonds carry a lower rating because the issuing entity is considered to have a greater than average default risk – that is, there is a risk that it would not be able to pay its debts and be forced into bankruptcy. Should bankruptcy occur, bondholders would probably receive significantly less than the face amount of the bonds.

Because of that elevated risk, junk bonds may yield as much as 1400 basis points – 14% – more than triple-A Treasuries (in an expanding economy, the spread might narrow to 200 basis points). That normally happens at the bottom of a recession, as the receipts required to service the bond interest dry up. Average default on high-yield credits is actually quite low, around 3.2%. But in a recession it gaps out to as much as 12%.[5]

Use in portfolios

High-yield bonds can add additional income but carry higher risks. Because of these risks, authors disagree on their use in a portfolio. In a Bogleheads topic[6], the different approaches of investment authors Richard Ferri and Larry Swedroe is discussed: Ferri thinks that high-yield bonds have a place in portfolio design but Swedroe disagrees. The poor performance of some Canadian high-yield bond funds in 2008 has been noted by Luukko.[7]

Because of the higher risk, of this asset class, investors who decide to include high-yield bonds in their portfolios should consider two different approaches:

  • The amount of high-yield debt in the portfolio should be limited. Ferri[8] recommends that 20% of the total bond allocation be in high-yield debt.
  • Investors unwilling or unable to analyze corporate debt structure should consider using a high-yield bond mutual fund or exchange-traded fund for this asset class.

Filters to sort mutual fund performance can be obtained from Globefund and Morningstar. There is a Financial Wisdom Forum topic[9] discussing the Phillips, Hager, and North High-Yield Bond Fund, which has one of the best returns in this category. Unfortunately, that fund has now been closed to new investors and replaced for new investments by RBC High Yield Bond.[10]

References

  1. Wikipedia, High-yield debt, viewed Feb. 18, 2009.
  2. DBRS, Long-Term Obligations | Ratings Scales, viewed November 27, 2012.
  3. Wikipedia, Michael Milken, viewed Feb. 18, 2009.
  4. Wikipedia, Drexel Burnham Lambert, viewed Feb. 18, 2009.
  5. Altman, Edward, Current Corporate Credit Conditions in the United States[dead link], 2004.
  6. Bogleheads.org, Swedroe versus Ferri on Recommended Asset Classes, viewed Feb. 23, 2009.
  7. Rudy Luukko, Tread carefully with junk bond funds, Feb. 21, 2009.
  8. Ferri, Richard A., All About Asset Allocation, McGraw-Hill, 2006. Page 149.
  9. Financial Wisdom Forum topic: Phillips, Hager and North High-Yield Bond, viewed Feb. 21, 2009
  10. RBC Global Asset Management, RBC Global Asset Management Inc. closes PH&N High Yield Bond Fund to New Investors, April 5, 2016, viewed February 27, 2017.