Newspaper article Sarasota Herald Tribune

Keep Junk Bonds in Your Portfolio?

Newspaper article Sarasota Herald Tribune

Keep Junk Bonds in Your Portfolio?

Article excerpt


A challenge facing many investors over the last few years is how to deal with low interest rates. Traditional investors in high- quality, safe, investment-grade bonds have been faced with yields at historical lows. This has caused many of them to consider riskier investments, such as high-yield bonds, also called "junk" bonds.

While these may sometimes be appropriate for aggressive investors, they are not appropriate for most risk-averse investors. To better understand why, let's consider why investors purchase high- quality, investment-grade bonds. There are three reasons: to provide more reliable income than from dividends or capital gains; to provide liquidity, since these bond prices are more stable than stock prices; to lower overall portfolio volatility. They are not there to generate high returns.

High-yield bonds do the opposite. Their income is not totally reliable, as they default at much higher rates than investment- grade bonds. They trade more like stocks than like investment-grade bonds, so they may not provide the needed liquidity. They don't help dampen portfolio volatility because they are highly correlated with stocks. Their main interest to investors is they can generate higher returns.

The key issue: Is the extra interest they pay over equivalent maturity U.S. Treasury bonds (the spread) large enough to cover principal lost to defaults? Keep in mind that, when a high-yield bond defaults, most of the time investors don't lose their entire principal. They recover on average about 40 percent.

Recently, the spread has been close to 5 percentage points, a bit below the historical median of 5.11 percentage points and much lower than in the 2008-09 period, when spreads were more than 20 percentage points.

But this is only part of the story. Recently, default rates were under 2 percent. Thus a diversified portfolio of high-yield bonds might expect a return of about 3 percentage points more than U.S. Treasuries, when adjusted for average recovery rates. This is in line with the historical median of 2.8 percentage points. But the historical median is 3.9 percent. …

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