Tick, tick, tick. That’s the sound of your impatience. In low-yield environments like today in the spring of 2017, investors are usually tempted to invest in high-yield bonds in order to capture higher yield. These investors are usually under the impression that, since high-yield bonds are still bonds, after all, such high-yield bonds should still be safe investments. Much to their surprise in the future, this approach is closer to playing with a bomb that is about to detonate.
High yield bonds, better known as junk bonds, are characterized as all non-investment grade bonds, usually have a credit rating of BB or lower, and have less than optimal cash flows. These characteristics are what increase not only the yield but also the risk of the bond. On the other hand, not all junk bonds are created equal. When deciding to invest in these high yield bonds, investors look at the “spread”, or difference in yield between US treasury bonds and the respective junk bond. The greater the difference, the greater the risk, variability, and potential yield—creating a high-risk high-reward gamble. The game of high-yield bonds is quite risky with an average default rate of 4.2% according to Standard & Poor’s, and while these 4.2% completely fail, other times companies must refinance their bonds with new bonds with higher interest and coupon rates—creating a cycle of debt and an even worse cash flow position compared to before the new bond issue. If the situation didn’t look bleak before, in today’s market, excess returns are so small that if loss rates move slightly higher than average, junk bond investors will do worse than those investing in US treasury bills.
About to leap into the air on a skydiving expedition? In your quest to chase the highest gains, you may think that investing in these junk bonds is still safer than investing in equities. While this line of thought comes with its merit, the associated default risk is greatly pronounced. High-yield bonds are behind a majority of the volatility in the market—which is why every investor should observe extreme caution when investing in them. Thus, blindly investing in high-yield junk bonds is akin to skydiving with sizable holes in your parachute. After all, the bond portion of your portfolio should function as the safety parachute during the next unpredictable market crisis and should not spectacularly blow up in your face together with the equity portion of your portfolio.
Much like a ticking time bomb, Wall Street’s “sexiest investments” seem to be ready to explode in a rising interest rate environment. The companies behind the junk bonds will most definitely have difficulty as interest rates rise because it will make it more expensive to borrow money in the future, and the existing junk bond might quite possibly explode. While the junk bond industry is booming now and has risen dramatically over the last five years as interest rates have remained low globally, these Goldilocks conditions of globally low-interest rate will not persist eternally. The money outflows out of the high-yield bond market are not just contained to junk bonds, but have spilled over to the lower segments of the investment grade bonds market as well. The high yield market is an early indicator of trends in the lower tiers of the investment grade bond market. So, if you think a few junk bonds failing is not that big a deal, think again! It may become extremely significant very quickly in a rising interest rate environment. As a high-level corporate debt investor quoted in TIME magazine notes, “when someone says something is contained, you should run the other way. Things are never contained.” Investors should keep a great distance from these high-yield bond bombs, as they might explode at any future moment.
Sources: