I’m not a fan of high yield bonds. I say this because I subscribe to the view that stocks drive returns while bonds help cushion any falls.
I know this because when the stock market acts crazy, investors consistently run from stocks into bonds for safety. High-quality government bonds benefit and help offset stock losses.
However, high yield bonds don’t.
For those who don’t know, high yield bonds are like a loan to a company with a bad credit score. In theory, the market offers investors a higher yield in exchange for taking an equally higher risk of not getting paid in full.
For the most part this works until the economy slows down, business slows down, and these companies have a harder time paying their debts. What you get are bonds that tend to act like stocks. You might notice similarities between the two in the asset class table.
The table below compares the movement of high yield bonds (BofAML US High Yield Index) against stocks (S&P 500) back to 1987.
|How Often High Yield Bonds and Stocks Move Together|
|Both Rise||Only Stocks Rise||Only Bonds Rise||Both Fall|
|# of Years||22||1||1||4|
|% of Years||79%||4%||4%||14%|
About 93% of the time, stocks and high yield bonds moved together. For reference, stocks and high-quality bonds move together about 60% of the time.
If volatility is your concern, you’ll want high-quality bonds, not high yield, for stability when things seem to be falling apart. So I’m all for only owning high-quality government bonds in the bond allocation. But it only works if you accept the tradeoff of lower yields.
There in lies the problem.
Now, investors own high yield bonds for two reasons: to take advantage of mispricing in distressed debt or for more yield. I’ll take a shot in the dark that most investors aren’t hunting for distressed debt opportunities (because most investors don’t see value in things that look bleakest), so my focus here is on yield chasers.
Investors love to hunt for higher yield. For awhile they’re satisfied, but eventually they spot a shiny higher yield off in the distance. They investigate. Indeed, the higher yield always looks better when you ignore the risks. Which is exactly what many investors do.
This might work for awhile until the stock market acts crazy again. Earning an extra few percent is great until you lose your principal or volatility drives you to sell after a short term loss. And less stability from bonds means your portfolio takes a bigger hit than it should.
If you relate this to today, investors are looking for more yield, finding it in high yield bonds, and swapping out stability for more risk because the higher yield looks better.
What they don’t realize is they’re paying for a slightly better yield on an asset with an exponentially larger risk than government bonds. In other words, their paying for the chance to earn a smidgeon more but with the potential to lose a lot. It’s analogous to buying stocks at any price.
Of course, this won’t leave you with too many options if you currently own high yield bonds. You can own high yield, but I believe it should be considered part of the equity side of your portfolio with the understanding of the risks involved. Or you can avoid high yield bonds because the slight benefit in yield is easily outweighed by the greater downside risk involved.
I prefer to avoid it. Besides, there’s no rule stating you must own high yield bonds in your portfolio.