High-Yield Bonds: The Most Dangerous Income Investment in the World
By announcing a $40 billion per month, open-ended asset purchase program (QE3), the Fed sent a clear message: Interest rates are going to remain at historically low levels for much longer.
That’s great if you want to re-finance your house. But it sucks if you’re hoping to earn a respectable yield on your hard-earned savings without taking on unnecessary risk.
I wish it weren’t true. But the hope of earning 5% on a certificate of deposit like we could about six years ago isn’t going to be realized any time soon.
Instead of accepting the paltry yields for longer, though – which would be a prudent move – investors are engaging in increasingly risky behavior. They’re piling into high-yield bonds.
Case in point: In the week following the Fed’s announcement, investors plowed $1.36 billion into high-yield bond funds according to Lipper. It marked the sixteenth week in a row of consecutive inflows.
Seven Reasons to Avoid High-Yield Bonds
Whatever you do, don’t join the stampede into high-yield bonds. And here are seven reasons why…
A Low, High-Yield Investment: Pardon the oxymoron, but right now high-yield bonds are actually sporting near record-low yields. In September, the average yield for high-yield bonds checked-in at 6.98%. That’s about 30 basis points shy of the all-time historically low yield of 6.7%.
Keep in mind, during the financial crisis, yields reached upwards of 15% for high-yield bonds. So the only direction yields are going to head from here is higher. And since bond prices and yields move in opposite directions, if we invest in high-yield bonds right now, we all but guarantee we’ll suffer capital depreciation.
Buy High, Sell Higher?: It’s not just yields that are trading at the wrong extreme, so are prices. High-yield bonds are trading above par value. That means investors are actually paying a premium to own high-yield bonds.
If we compare high-yield bond prices to stocks, they’re expensive, too. In fact, high-yield bonds are trading at their most expensive level on record compared to stocks, based on the earnings yield of the S&P 500. The implication is that stocks are a much better bargain than high-yield bonds.
More Defaults on the Horizon: Despite weak global economic growth, the default rate on high-yield bonds is within spitting distance of an all-time low at around 3%. It’s only a matter of time before a “reversion to the mean” occurs. In other words, more companies are bound to start defaulting, bringing the default rate back to its historical average. And defaults, in turn, lead to more losses.
Now, Moody’s doesn’t expect the default rate to increase noticeably for at least another year. But Standard & Poor’s says we’ve passed the peak in credit quality. “We expect to see diminishing credit quality as the cycle continues,” says Diane Vazza, Head of Global Fixed Income Research.
Whether it’s a year from now or next month, defaults are destined to head higher, making high-yield bonds increasingly risky. And when defaults pick up, it’s going to spook investors out of high-yield bonds. Think “Last-In, First Hurt.” Anyone investing now will suffer the most harm (i.e. – losses).
When Being Cash Rich is a Bad Thing (Part 1): A recent report from Jonathan Mackay, Senior Fixed Income Strategist at Morgan Stanley (NYSE: MS), reveals, “Credit investors have high levels of cash.” Translation: Money managers are going to get antsy to invest despite market fundamentals, simply because they don’t get paid to keep investors’ money in cash. And adding more money to limited opportunities doesn’t lead to the most profitable investments.
When Being Cash Rich is a Bad Thing (Part 2): In May, the Vanguard High-Yield Corporate Fund (VWEHX) stopped accepting money from new investors. The only reason to do so is because demand is outstripping the supply of attractive investments. Again, the move should raise a big red flag to investors considering new investments in high-yield bonds.
A Target-Poor Environment: Vanguard isn’t the only industry insider raising red flags about the limited pool of attractive investments. Barclay’s Head of Credit Research, Jeffrey Meli, says, “Investors have flocked to the highest-quality part of both high-yield and investment-grade nonfinancial industries,” and the remaining opportunities are in lower-quality (i.e. – riskier) issuers. In other words, investing in high-yield bonds right now means taking on more risk.
Don’t Count on Corporate Responsibility: According to Informa, companies sold a record $143 billon worth of bonds to investors in September. Sales of high-yield bonds hit a record high, too, at almost $50 billion. However, just because companies are selling bonds doesn’t mean we should be buying them. Quite the opposite is true, actually. When companies are so eager to issue debt, we should be less eager. It’s a sign of a market top. They’re rushing to finance debt at record lows before it’s too late.
Timing is Everything
Bottom line: Chasing performance and yield is never a successful investment strategy. So instead of fighting it, accept the fact that the time to invest in high-yield bonds has passed.
While the yields might be attractive, they’re only attractive in relation to the sub-2% yields on U.S. government bonds. Historically speaking, they’re actually low. Moreover, the risks are only increasing, not decreasing. And we want more yield, not more risk.
Ahead of the tape,