High-yield bonds even more risky with rising chances of recession | The Rational Investor
With inflation at 8.5%, the cupboard is bare for investors seeking “safety” and inflation-like returns in fixed income. Recently, the 10-year Treasury Note interest-rate was about 2.9% and the 30-year bond about 3.2%. Not quite as safe A-rated corporate bonds yield a bit more than 4.25%. CD rates are also anemic with one-year, at best, 2.5%, and five-year, at best, 3.25%. This sometimes leads investors who eschew the volatility of stocks and need higher returns to sacrifice the safety of these investments and seek those returns elsewhere.
Unfortunately, none of the available alternatives are without risk to principal. Here we focus on high-yield bonds, also known as “junk bonds.” Recall, bonds are rated for safety, for example, by Standard & Poor’s from AAA to D. Those rated BB+ or lower are known as high-yield bonds. Even with their significant risk, over the last few years they became popular with professional advisers. However, with the rising chances of a recession in the next 12 months, their risk is even higher due to their increased probability of default.
In a recession junk bond buyers face a heightened risk – as compared to investment-grade bonds – that that they will not see the promised interest payments or the return of their initial investment. That is because these bonds have default rates significantly higher than investment-grade bonds. While the latter have a default risk of about .1%, junk bonds have a historical median default rate of 3.9%. However, during recessions, annualized junk bond default rates of 5% or much more are realistic.
The real question: Is the extra interest they pay over equivalent maturity U.S. Treasury bonds (the spread) large enough to cover principal lost to default? Recently, the spread has been about five percentage points, essentially the historical median. When a high-yield bond defaults, an investor often does not lose his entire principal; historically, about 60%. However, in a recession, losses can be much higher. Another critical issue about default rates is they vary significantly with junk bond ratings.
A diversified portfolio of junk bonds with an average rating of BB might expect a net return of about 1.6 percentage points more than U.S. Treasuries, when adjusted for a 40% recovery rate and a 5% default rate. Of course, a higher default rate and/or a lower recovery rate could easily wipe out any extra return. Even if the economy avoids a severe recession, it’s not obvious that the current slower growth won’t increase the default rate.
What would happen to these bonds if, as is almost certain, the Fed continues to increase interest rates? Fortunately, high-yield bond prices are less sensitive to interest rate changes than are investment grade bonds, so there won’t be much additional impact beyond any price declines due to the increased default risk.
High-yield bonds are at most for very aggressive investors after careful due diligence. Those investors should focus on bonds rated at least BB with five years or less to maturity. Additionally, it’s critical to have a diversified portfolio of about 20 bonds, so that the default of one does not devastate the portfolio.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.
This article originally appeared on Sarasota Herald-Tribune: ROBERT STEPLEMAN: High-yield bonds are getting even more risky
