While high-yield corporate bonds may offer higher returns, they also come with a great deal of risk. In this episode of Buckingham Weekly Perspectives, Head of Investment Research Jared Kizer takes a deep dive into these securities and shares why we don’t recommend this fixed income strategy.
So today we’re going to talk about high-yield corporate bonds, a type of fixed income investment that we frequently get asked about but don’t typically recommend or basically ever recommend in client portfolios. So, I wanted to jump in and talk about what high-yield corporate bonds are, then talk about some of the reasons historically that we haven’t recommended them in client portfolios.
What are high yield corporate bonds?
Jared Kizer: So high-yield corporate bonds, as the name might suggest, are relatively high yielding or high expected return forms of fixed income investing. So, they are fixed income, but on the riskier end of the scale and high-yield bonds almost always refers to higher-yielding corporate bond issuers. So, these are companies that are issuing bonds, but companies that are much much riskier typically than the typical company or what would be called an investment grade company. So, think of more distressed companies that are public companies, but more distressed and higher risk than the typical company that most of us are familiar with.
So therefore, when those companies are issuing bonds, they issue bonds at no doubt at much higher interest rates than say a Walmart or Google, Apple or Microsoft would be paying on their bonds because of that higher risk. So, we see investors can be attracted to high-yield corporate bonds because of those higher-yields and no doubt historically the bonds have had higher net returns than safer a fixed income, but we’ll touch on why that’s only part of the story and why we think is not enough to recommend them typically in client portfolios.
Higher returns = Higher risks
Jared Kizer: And we start there with yes returns a bit higher, but so is risk. So, you do see that on average about 1% to 2% of the yield that you’re earning on high-yield corporate bonds has been lost to defaults each year, so riskier companies. Yes, it’s fixed income but some of these companies will no doubt default over the course of a typical year. And of course, more of those companies will default during periods of prolonged stress and broader markets and the broader economy and that I think is the most important reason which we’ll touch on now while we haven’t recommended them historically. So, I think of high-yield corporate bonds almost as junior equities, so they’re very equity-like even though they are a fixed income investment. So, they’re not a great way to diversify a portfolio, said another way, most all clients that we work with and most investors in general will have some portion of their allocation dedicated to stocks. So, if you’ve got that part of your allocation, you’re kind of already getting what high-yield corporate bonds provide. So, if you separately then allocate what the high-yield corporate bonds provide, you’re kind of doubling up on risk that you’ve already got in your portfolio and doubling up on it in a way that’s not that tax efficient either. So, when we think about stocks, one of the nice characteristics they have is that they do tend to be relatively tax efficient. So in sensible stock strategies, you don’t lose a lot of return each year to tax related costs if you’re investing in a taxable account. Not true with fixed income – you’re taking equity like risks, but you’re going to be taking it in ways that would be taxed at traditional ordinary income rates. So just not a great diversification agent relative to other strategies that are out there in the marketplace. For example, some of the alternative strategies that we typically recommend and again in many ways you’re taking equity-like risk with less preferential tax treatment. So hopefully that’s a helpful kind of brief introduction to high-yield corporate bonds and the way that we think about them and why we don’t recommend them. If you have additional questions you’d like for us to tackle, feel free to reach out to your advisor. Or click the link below and submit questions in that way. Thanks.