Reaching for Yield: Junk and Other High-Risk Bonds

Reaching for Yield: Junk and Other High-Risk Bonds

In this concluding article in the series exploring different ways investors might attempt to increase the income generated by their portfolios, we look at high-yield bonds. These securities offer a higher coupon payment than Treasuries and investment-grade corporate bonds at the cost of higher default risk. Default risk is particularly onerous because it offers a small upside and potentially a very large downside. For example, holders of the prophetically-named Catastrophe Bonds issued by Mariah Re Ltd. collected a generous 7% coupon for one year until the 11/29/2011 announcement that stated this past summer’s weather-related insurance claims were far higher than anyone had predicted, so the bonds would no longer pay a coupon and bondholders would lose 100% of their principal. Ouch! The salient lesson for investors here is to avoid dabbling in ventures that are normally undertaken by entities with a high level of relevant experience and expertise. In this particular case, the risk assumed by investors was one that is normally borne by insurance companies that have a brain trust of actuaries to analyze these types of risks. The fact that no insurance companies were touching these bonds should have been a red flag. Another recent egregious example of the perils of default risk is MF Global, which was given an investment-grade rating by Moody’s only a few days before it declared bankruptcy. This debacle revealed a truly horrible financial mess in which $1.2 billion of client funds were siphoned away, a stunning act of malfeasance that should never have occurred in a brokerage firm. As of December 27th, MF Global bonds were trading at 33 cents on the dollar. Even when the government bails out a company, bondholders may still take it on the chin, as was learned by General Motors bondholders who received stock that was worth a fraction of their original investment. On the other hand, Uncle Sam can also be incredibly generous, as he was to the bondholders of the “Too Big to Fail” banks who lost not a single penny. Why the two groups were treated so differently is a mystery that may never be fully explained. Default risk can be somewhat mitigated by diversification among issuers and industry groups, and for most investors, the only viable way to achieve this diversification is with a bond mutual fund, especially since high-yield bonds often trade in an opaque and illiquid manner where retail investors are at a severe disadvantage. The chart below shows how the transaction cost varies with trade size for corporate bonds. Since these amounts are primarily for investment-grade bonds, the numbers for high-yield bonds are even worse. The authors of the study note that high yield bonds are almost twice as costly to trade as investment-grade bonds. Therefore, an investor who chooses to actively manage a junk bond portfolio has a high cost hurdle to overcome to achieve a higher risk-adjusted return than would have been obtained with a passively managed high quality bond fund. As for investors in actively managed high yield mutual funds, 92% of them failed to beat the Barclays High Yield Bond Index over the last 3 and 5 years ending June 30th, 2011, according to Standard & Poors Indices Versus Active Funds Scorecard (SPIVA ®)1.

While the offered yields of distressed debt securities (often more than 10% over the equivalent maturity Treasury Bond) may be extremely tempting, retail investors operate at a severe informational disadvantage compared to the institutional players like Goldman Sachs. Index Funds Advisors cautions investors not to venture into an arena where so few have enjoyed long-term, consistent success. IFA continues to advise investors to use fixed income as a portfolio risk reducer and to take their risk in equities where the long-term payoff has been significantly higher than fixed income. 1http://www.standardandpoors.com/indices/spiva/en/us