During the 1980s and 1990s, high yield bonds evoked thoughts of investment scandals and unscrupulous financiers like Michael Milken and Ivan Boesky, who ended up being depicted in newspapers and on TV as “junk bond kings.” Many investors still favor the relative safety of investment grade bonds like U.S. Treasurys. But interest rates on all higher quality bonds have been gradually deteriorating for many years. Now they’re at record lows, making it very hard to set up a good bond portfolio for retirement. Now could be a good time to take another look at high yield bonds, because it’s among the few areas that offers good interest rates in today’s markets.
As a fixed income investor, you've got a numerous possible choices. First, you could invest in high grade bonds, often issued by federal or state governments. Second, you could invest in highly rated AAA or similar corporate debt. Doing this would be fairly safe. As a matter of fact, some corporations are now actually paying lower interest than many sovereign (government) bonds. Finally, you can invest part of your savings in high yield bonds.
Purchasing individual high yield securities is not a practical approach for the majority of individual investors. The bond market is dominated by institutional players, who spend their days pouring over corporate financials and putting together portfolios of the highest possible returns and the least amount of risk. Luckily, there are lots of excellent high yield bond funds and ETFs that you can buy. They are managed by professional portfolio managers, and provide the necessary benefit of diversification. For instance, the two most common high yield bond ETFs (with ticker symbols JNK and HYG) currently hold 223 and 446 different fixed income securities within their portfolios respectively. The same is true for many of the available high yield bond mutual funds: they hold hundreds of individual securities, managing some of the risk of default and capital depreciation. You can go to Morningstar, Yahoo Finance or other popular investment websites and easily find good high yield mutual funds. If you're planning to buy and hold junk bond funds for a long duration, ETFs have the advantage of lower expense ratios (compared to mutual funds).
You need to be somewhat careful about when to invest in high yield. One approach is to track the interest “spread” (the difference in interest rates) between high yield and high grade securities. High yield bonds typically yield between 4 and 6 percent more than bonds that are considered less risky. During economic crises, this spread rises, as investors sell speculative bonds and buy government as well as other less risky bonds. Companies selling high yield bonds then must pay a high rate of interest to get investors to buy their bonds, so the spread may be 6% or sometimes even higher. This is frequently a good time to buy high yield bonds. For instance, during the global financial crisis in 2008 and 2009, the high yield spread increased to more than 7% over U.S. Treasury Bonds. And high yield bonds have gained a lot in value since that time.
It's also advisable to be aware that high yield bond prices usually go down during economic recessions. So in a way, they behave like stocks. This means potential investment losses.
Don’t allow the bad reputation of high yield bonds prevent you from seriously considering them as a source of high current income for your retirement portfolio. But bear in mind that high yield bonds are a lot riskier than many higher grade fixed income securities. With the added yield comes increased risk -- there’s no free lunch.
