Stay Cautious with High-Yield.
As you well know, interest rates are achingly low; short-term rates are near zero. That’s why investors seeking a better return are looking in all kinds of nooks and crannies of the investment world, places which might be beyond their normal level of comfort or expertise.
A brief reminder about higher rates: there is generally only one reason a borrower (the entity that issues bonds) pays out a higher rate of interest – they are seen by the marketplace as being more risky than other borrowers. In other words, less stable borrowers have to pay out more to compensate for the risk they are asking you (the lender) to take.
High-yield bonds are called junk bonds because they carry the most risk. The safest fixed-income instruments, on the other hand, are those issued by the U.S. Treasury. Barring some political disaster, the world understands that our government debt will always be paid back and so the interest rate on those bonds is always the bedrock rate. Everyone else – state and local governments, foreign countries, corporations anywhere — must pay a higher rate to get investors to loan them money.
But lately, things have gotten a bit wacky as yield-hungry investors crowd into higher-yielding bonds. As a result, now you will get less of a return for riskier bonds. That makes me a bit nervous.
To put this all into actual numbers – average high-yield rates peaked at an astounding 23.2 percent at the end of 2008 during the height of the financial crises. Last week, however, average junk-bond yields tumbled to 5.29 percent, and that is a record low.
Extremes in life are almost never good, and that is certainly true in investing. In this case, that 5.29 percent is just 3.65 percentage points in extra yield above comparable rock-solid Treasurys; that’s a razor thin spread. At times in the not-distant past the spread has been more than ten percentage points above Treasurys.
In this situation, two bad things can happen – either interest rates rise, which will cause your bond (or bond share) prices to fall, or default rates go up. Or both.
So while a small position in junk bonds may be reasonable, caution is strongly advised.