High Yield Bonds – Remember Their Nickname

Friday, February 19, 2010

Many individual and institutional investors have bought high yielding bonds over the past months. One publication noted that pension funds liked them because of their “competitive” returns. There are also articles about the improved state of the market – that new bond issues meet with willing buyers. Wall Street loves them – but should you?

Like all bonds, there is the risk that rates will increase, causing bond prices to go down. (Because interest payments are fixed, the price must move to adjust the bond’s yield.) As I have described, there is a good chance that this adverse move will occur as the Federal Reserve allows short-term rates to rise and as the economy continues to improve.

For high yield bonds, the other, big risk is credit. (Here is where an improving economy can help, if it restores sales and earnings to weak companies – so they can make their high interest payments.) Higher yields are a red flag indicating poor credit quality. Because bond investors search for ways to earn a few basis points of added yield (each basis point is 1/100 of a % = 0.01%), a bond paying over a hundred basis points more is a very red flag. How red? These bonds also carry the label “junk.”

To see how the credit risk is described for these bonds, take a look at the definitions below (high yield/junk bonds carry non-investment grade ratings).

Clearly, we need to be careful when buying such bonds. They require taking on a lot of credit risk to get those higher yields. Just a reminder…

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