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High Yield Bonds: Proceed With Caution
From time to time we comment on high yield bonds (sometimes called “junk bonds’) because we think they may be of interest to turnaround investors for several reasons. While they are called bonds, many high yield issues have return – and risk – characteristics closer to stocks than to other fixed income instruments. Also, many companies that issue high yield debt are in the process of turning around, or at least trying to. And some high yield issuers don’t make it, file for Chapter 11 and eventually provide interesting distressed bond or post-bankruptcy stock opportunities.
While we like high yield bonds generally as a place to invest – the BofA Merrill Lynch High Yield Index has a solid 10-year annualized total return of 7.3%, and it has only been down in six years since 1987 – we are cautious about the asset class right now for a couple of related reasons. First, high yield bonds seem fairly expensive by historical standards. After the asset class had a tough year in 2015, many investors, who were desperate for yield, rushed back into junk bonds in 2016. As a result, the BofA index rose 17% last year. While not at historic low levels, the yields on most junk bonds have fallen considerably over the last year or so to the point where we think they may not compensate you for the risks you are taking on – there is a reason they are called “junk” bonds after all.
Speaking of the risks, we believe that defaults are going to increase over the next few years in sectors outside of energy (which saw historic numbers of defaults last year). As we have commented before, there are huge quantities of bonds across all sectors that come due over the next few years, and some meaningful fraction of those bonds will default. This increase in defaults is likely to spook many high yield investors, pushing bond prices down. Also, as interest rates inevitably rise further, that will create more volatility in the high yield markets.
All of that said, we do believe that there should be a place for high yield bonds in most portfolios. We just recommend proceeding cautiously, perhaps increasing your exposure to the asset class gradually over the next several years. Also, we believe that high yield is an area where actively managed mutual funds are likely to outperform index funds and ETFs.