Although they are considered risky investments, high-yield bonds—commonly known as junk bonds—may not deserve the negative reputation that still clings to them. In fact, the addition of these high-risk bonds to a portfolio can actually reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation.

Let's look more closely at what high-yield bonds are, what makes them risky, and why you may want to incorporate them into your investing strategy. High-yield bonds are available to investors as individual issues, through high-yield mutual funds, and as junk bond ETFs.

KEY TAKEAWAYS

  • High-yield bonds offer higher long-term returns than investment-grade bonds, better bankruptcy protections than stocks, and portfolio diversification benefits.
  • Unfortunately, the high-profile fall of "Junk Bond King" Michael Milken damaged the reputation of high-yield bonds as an asset class.
  • High-yield bonds face higher default rates and more volatility than investment-grade bonds, and they have more interest rate risk than stocks.
  • Emerging market debt and convertible bonds are the main alternatives to high-yield bonds in the high-risk debt category.
  • For the average investor, high-yield mutual funds and ETFs are the best ways to invest in junk bonds.

Understanding High-Yield Bonds

Generally, a high-yield bond is defined as a debt obligation with a bond rating of Ba or lower according to Moody's or BB or lower on the Standard & Poor's scale. In addition to being popularly known as junk bonds, they are also referred to as "below investment-grade." Low ratings mean that the company's financial situation is shaky. So, the possibility that the firm could miss making interest payments or default is higher than those of investment-grade bond issuers.

A bond classification below investment-grade does not necessarily mean that a company is mismanaged or engaged in fraud. Many fundamentally sound firms run into financial difficulties at various stages. One poor year for profits or a tragic chain of events can cause a company's debt obligations to be downgraded. Some of the top companies in the S&P 500 have suffered the indignity of having their bonds downgraded to "junk" status. For example, in 2019, Moody's downgraded the debt issued by automotive icon Ford to below investment-grade.

The opposite can also happen. The bonds issued by a young or newly public company may be low-rated because the firm does not yet have a long track record or financial results to evaluate.

Whatever the reason, being considered less creditworthy means borrowing money is more expensive for these companies. They have to pay more interest on their debt, the same way individuals with low credit scores often pay a higher APR on their credit cards. Therefore, they are called high-yield bonds. They offer higher interest rates because of the additional risks.

Advantages of High-Yield Bonds

Higher Returns

As a result of the increased interest rates, high-yield investments have generally produced better returns than investment-grade bonds. High-yield bonds also have higher returns than CDs and government bonds in the long run. If you are looking to get a higher yield within your fixed-income portfolio, keep that in mind. The number one advantage of high-yield bonds is income.

Bankruptcy Protections

Many investors are unaware of the fact that debt securities have an advantage over equity investments if a company goes bankrupt. Should this happen, bondholders would be paid first during the liquidation process, followed by preferred stockholders, and lastly, common stockholders. This added safety can prove valuable in protecting your portfolio from significant losses, reducing the damage from defaults.

Diversification

The performance of high-yield bonds does not correlate exactly with either investment-grade bonds or stocks. Because their yields are higher than investment-grade bonds, they're less vulnerable to interest rate shifts. This is especially true at lower levels of credit quality, and high-yield bonds are similar to stocks in relying on the strength of the economy. Because of this low correlation, adding high-yield bonds to your portfolio can be an excellent way to reduce overall portfolio risk.

High-yield bonds can act as a counterweight to assets that are more sensitive to interest-rate movements or overall stock market trends. For example, high-yield bonds as a group lost far less than stocks during the financial crisis in 2008. They also rose in price as long-term Treasury bonds fell in 2009, and high-yield bond funds generally outperformed stocks during that market rebound.

The Bad Reputation of High-Yield Bonds

If they have so many pluses, why are high-yield bonds derided as junk? Unfortunately, the high-profile fall of "Junk Bond King" Michael Milken damaged the reputation of high-yield bonds as an asset class.

During the 1980s, Michael Milken—then an executive at investment bank Drexel Burnham Lambert Inc.—gained notoriety for his work on Wall Street. He greatly expanded the use of high-yield debt in mergers and acquisitions, which in turn fueled the leveraged buyout boom. Milken made millions of dollars for himself and his Wall Street firm by specializing in bonds issued by fallen angels. Fallen angels are once-sound companies that experienced financial difficulties that caused their credit ratings to fall.

In 1989, Rudolph Giuliani charged Milken under the RICO Act with 98 counts of racketeering and fraud. After a plea bargain, he served 22 months in prison and paid over $600 million in fines and civil settlements.

Today, many on Wall Street will attest that the negative perception of junk bonds persists because of the questionable practices of Milken and other highflying financiers like him.

Risks of High-Yield Bonds

Default Risk

High-yield investments also have their disadvantages, and investors must consider higher volatility and the risk of default at the top of the list. According to Fitch Ratings, high-yield bond defaults in the U.S. fell to 1.8% in 2017. However, the rising level of corporate indebtedness around the world troubles many analysts and economists. High-yield default rates in the U.S. reached 14% during the last recession in 2009, and they are very likely to rise again during the next downturn,

You should be aware that default rates for high-yield mutual funds are easily manipulated by managers. They have the flexibility to dump bonds before defaults and replace them with new bonds.

How can you more accurately estimate the default rate of a high-yield fund? You could look at what has happened to the fund's total return during past downturns. If the fund's turnover is extremely high (over 200%), this may be an indication that near-default bonds are being replaced frequently. You could also look at the fund's average credit quality as an indicator. This can show you if the majority of the bonds being held are just below investment-grade quality at BB or B on the Standard & Poor's scale. If the average is CCC or CC, then the fund is highly speculative because D indicates default.

You should be aware that default rates for high-yield mutual funds are easily manipulated by managers.

Interest Rate Risk

Another pitfall of high-yield investing is that a weak economy and rising interest rates can worsen yields. If you've ever invested in bonds in the past, you're probably familiar with the inverse relationship between bond prices and interest rates. As interest rates go up, bond prices will go down. Though they are less sensitive to short-term rates, junk bonds closely follow long-term interest rates. After a long period of stability that kept investors' principal investments intact, the Federal Reserve raised interest rates repeatedly in 2017 and 2018. However, the Fed reversed course and cut rates in 2019, leading to gains across the bond market.

During a bull market run, you might find that high-yield investments produce inferior returns when compared to equity investments. Fund managers may react to this slow bond market by turning over the portfolio. That will lead to higher turnover percentages and add additional fund expenses that are ultimately paid by you, the end investor.

In times when the economy is healthy, many managers believe that it would take a recession to plunge high-yield bonds into disarray. However, investors must still consider other risks, such as the weakening of foreign economies, changes in currency rates, and various political risks.

Alternatives to High-Yield Bonds

Emerging Market Debt

If you're looking for some significant yield premiums, domestic junk bonds aren't the only asset in the financial sea. Emerging market debt securities may be a beneficial addition to your portfolio. Typically, these securities are cheaper than their U.S. counterparts in part because they have much smaller domestic markets individually. As a group, they account for a significant portion of global high-yield markets.

Convertible Bonds

Some fund managers like to include convertible bonds of companies whose stock price has declined so much that the conversion option is practically worthless. These investments are commonly known as busted convertibles and are purchased at a discount since the market price of the common stock associated with the convertible has fallen sharply.

Other Alternatives

Many fund managers are given the flexibility to include certain other assets to help diversify their investments even further. High-dividend-yield common stocks and preferred shares are comparable to high-yield bonds because they generate substantial income. Certain warrants also have some of the speculative characteristics of junk bonds. Another possibility is leveraged bank loans. These are essentially loans that have a higher rate of interest to reflect the higher risk posed by the borrower.

The Bottom Line

For the average investor, high-yield mutual funds and ETFs are the best ways to invest in junk bonds. These funds offer a pool of low-rated debt obligations, and the diversification reduces the risk of investing in financially struggling companies.

Before you invest in high-yield bonds or other high-yield securities, you should be aware of the risks involved. After doing your research, you may want to add them to your portfolio if you feel these investments suit your situation. The potential to provide higher income and reduce overall portfolio volatility are both good reasons to consider high-yield investments.