Jared Kizer takes a deep dive into high-yield corporate bonds and shares three reasons why these investments are not recommended from an allocation perspective.
So today I’m going to talk about high-yield fixed income investing, what it is and why we generally don’t tend to recommend allocating to high-yield fixed income.
What is High-Yield Fixed Income
So let’s first cover the what it is part. What is high-yield fixed income? So these are publicly-traded securities that pay principal and interest that are issued by relatively financially distressed companies. So they’re publicly traded, but you can think about these companies being smaller companies, companies that are at some higher risk of bankruptcy, say over the next year relative to the companies that we all know better and companies that generally aren’t growing as fast as other companies. So, they’re riskier, but the appeal to investors as you’ll tend to see, as you would hope, markets do tend to offer these fixed income investments at much higher interest rates than say Treasury bonds, municipal bonds or government bonds.
Three Fast Facts About High-Yield Fixed Income
But let’s get into why we generally don’t think allocating to high-yield fixed income make sense and we’ll cover really three different topics and aspects of that perspective.
This Hybrid Security Follows the Lead of the Stock Market
So the first thing is we think of high-yield fixed income is what we would call a hybrid security. That sounds fancy, maybe a little bit complex, but it’s actually a relatively straightforward concept. It is just saying that when you think about high-yield fixed income and these risk issuers being riskier than higher quality issuers, you tend to see that high-yield fixed income will tend to do poorly at the same time that the overall stock market is doing poorly. Meaning because these are financially distressed issuers, they’re more sensitive to negative developments in the economy, so they tend to have aspects that are a little bit like stocks, maybe a little bit like fixed income and tend to be more like stocks at the worst possible time, therefore not providing the diversification that we would like to see from fixed income investments.
There is Less Control Regarding Asset Allocation
That segue ways nicely into my second point, which is because they are this hybrid type of security that’s hard to classify, it does end up muddling the allocation to some degree. So when you think about allocation, we think about allocating to stocks, bonds and alternatives as the three predominant groups of an overall allocation. And here really high-yield fixed income doesn’t necessarily fit cleanly into any one of those buckets. So when you allocate to fixed income, to some degree, you lost control of your overall allocation, muddying the allocation a little bit.
Stocks May Be a Better and More Tax-Friendly Option
I think third is probably the most pertinent point, either the first point or the third point. Being that if you’re comfortable with this type of risk, meaning owning riskier bonds from riskier companies, there’s certainly a good argument I think for just owning the stocks of these companies in a diversified portfolio as some portion of the allocation because you’re likely going to get more favorable tax treatment, just owning the stock versus the fixed income side. And last point I would make as part of point number three is if you’re comfortable with this type of risk, but you want a fixed income type security, we would say private market, middle markets lending, so lending to privately held companies tends to we think over the long term be a better risk return trade off. You just tend to see those private loans have even higher interest rates than high-yield corporate fixed income, so that could be another direction that might make sense to go as an alternative to traditional high-yield fixed income.
So hopefully, that’s a helpful perspective on what high-yield fixed income is and why we don’t generally recommend allocating to it. 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.