Investing in High Yield Corporate Bonds
August 28, 2007
We have some junk in our portfolio, junk bonds that is. About 5% of our portfolio is invested in junk bonds and today I’m taking a closer look at them due to their poor performance this year.
What Makes Them Junky?
When a company wants to sell bonds to raise money but their debt isn’t deemed “investment-grade” by credit rating companies the bond is rated as a lower quality. Companies like S&P and Moody’s look at things such as cash flows and debt on the balance sheet when rating a company’s potential ability to pay its debts. Junk bond is the term used to refer to bonds rated BBB by S&P or Baa by Moody’s.
Who Are These Junky Companies?
The companies that are looking to raise capital with less than stellar debt ratings are often either new enterprises in the beginning stages of development or established companies that have struggled financially. The newer companies don’t have much of a financial history to base an analysis on so they’re deemed less likely to be able to make interest and principal payments until proven otherwise.
In addition, some established companies that used to have an investment-grade rating have been downgraded to junk bond status. Since the risk of lending to companies with worse credit is higher, they have to pay higher interest rates to entice investors to loan them money, hence the name high yield corporate bonds.
Why Invest in Junk?
One role that junk bonds play in a portfolio is that their returns and risk profile tend to fall between those of stocks and investment grade bonds. According to Fidelity:
“high yield bonds tend to be less sensitive to interest-rate movements than investment-grade bonds, and are more sensitive to the factors that influence stock prices, such as a company’s business prospects, cash flow, and debt level, as well as industry fundamentals and the overall health of the economy….
At the same time, high yield bonds are fixed-income securities that derive the bulk of their return from coupon payments (income), which makes them less volatile than stocks and provides downside protection.”
Hard Times for Junk Bonds?
An article in the Chicago Tribune warns of tough going for junk bonds in the near future. Slower profit growth and rising debt levels could lead to higher volatility. Scott Berry of Morningstar Inc., warns “keep reasonable expectations for the [high-yield] asset class. It’s not offering a lot of yield for the risk, and double-digit returns are going to be difficult to get.”
Junk bonds have definitely taken a hit recently. Our investment in Vanguard High-Yield Corporate fund (VWEHX) dropped in value for all of June and July to prices it hadn’t reached since December of 2002. Although the fund has a 5 year annualized return of 8.16%, the year to date return has been not so good, -1.58%. Things have improved some with an upward trend over the last month but it could be rough going for a while for junk bonds.
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All posts by Ben Edwards