Higher yield, junky risks
Joel Dresang: So, Brian, we’ve had low interest rates for a long time, and you’ve cautioned people about chasing yields. What about junk bonds? Let’s talk specifically about where they are right now.
Brian Kilb: Okay, Joel. Just a few months ago, junk bonds, or lower-quality bonds, were yielding in the neighborhood of 4% to 5% – historically, a little lower than normal. These days, those yields have increased significantly, and you’re getting 7%-8% for those same bonds.
So the risks on those bonds have increased. In order to get you interested in those bonds, I’ve got to pay a little bit more. The price of the bonds also goes down as a result.
So you’ve had a deterioration in bond prices in junk bonds and an increase in bond yields.
Joel: Why don’t we step back and define what junk bonds are?
Brian: Junk bonds are just bonds that are issued by lower-quality companies. So, those are companies that have a higher risk of not paying you back all or part of that bond. Defined by the rating agencies, if you want a more technical answer, we typically call everything below triple-B rating – junk bonds.
Joel: They also have to pay higher yield to attract investors.
Brian: Well think about it, Joel. If I’m at risk of not paying you back, you’re going to want to get paid more for that risk. So, of course, I have to entice you with a higher yield. The question is how much of a higher yield is enough yield to get you interested?
Joel: So, what’s behind the latest movements in junk bonds?
Brian: Well, primarily it’s related to the energy field. A lot of lesser-quality companies were those energy companies that dove into the energy marketplace the last few years.
And with the reduction in oil prices, a lot of those guys are having trouble paying their bills these days. And that part of the market has caused us some problems in credit quality.
Joel: So, what does this mean for long-term investors?
Brian: Well, where do junk bonds belong in your portfolio? This is a higher-yielding instrument with higher risk. Do you consider that part of the safe component of your portfolio that we like to use bonds for?
I happen to think for the risk and reward involved, I like to think of it more in the stock world. I’m going to make some money, but there’s some risk here.
For that money that you want to be safe, that you don’t want to mess around with, that you want very little volatility, I don’t think junk bonds have a role in that part of your portfolio.
Joel: They have risks just like stocks do.
Brian: Yes. In the world of bonds, it’s a promise to pay you back a certain amount. But because of the risk involved – the underlying lack of strength, perhaps, of that company – because there’s a higher risk, the opportunities that you get to pay it back aren’t as good.
So, at what point in time do you have enough confidence you’re going to get that yield, versus it becomes more of a speculative thing? I just like to think of them more on the riskier side of the portfolio.
Joel: We’re talking about credit risk. What about interest rate risk?
Brian: Well, we’re also in a cycle where interest rates may be rising, so junk bonds, just like every other bond, may have some difficulties. Prices may diminish when rates are increasing.
So, not only do you have deterioration in the quality side of the junk bond market, but you have potential interest rate risk as well. It just sounds to me like a lot of risk for not as much return as you should expect as an investor.
Joel: So, for the safe part of your portfolio, you want to stick to quality.
Brian: Yes, I think so Joel. Let’s go back to a couple of periods in history: 1994 and just the financial crisis a few years ago. Junk bonds lost in the teens, in the low 20s.
That doesn’t sound like it should be part of the safe part of your portfolio, correct? That’s a big risk to take to generate a little bit more in yield.
So I think for the safe part of your portfolio, you want to avoid that kind of volatility. Get a little smoother ride, and stick to the higher-quality bonds.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
“Bond investors: Look at credit quality, spreads,” a Money Talk Video with Marc Amateis
“The Grass Isn’t Always Greener – Chasing Return in a Challenging Investment Environment,” an investor alert from the Financial Industry Regulatory Authority
“What Are High-yield Corporate Bonds?” from the Securities and Exchange Commission
(initially posted Oct. 16, 2015)
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