When Yield Isn’t Worth the Risk

Why chasing high-yield bonds may be a really bad idea.

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Are you disappointed in the low rate of return with bonds and CDs? Are you thinking you might take on a little more risk to get those few added percentage points of yield? Maybe you should think again. In this low rate environment, there is no such thing as a safe bond investment with a high yield. They are like unicorns; you can’t prove they don’t exist, but you can’t find any either. So if you are concerned with safety, what are your options? Statistics show that many people are turning to high-yield bonds and bond funds. So what’s the problem?

In our opinion, fixed income investments are designed to be a safe haven for your money and not necessarily a good income creator. In low interest rate environments, people seem to forget that and look for yield in dangerous places. These places like high-yield bonds (which used to be called junk bonds) got a bad name several years ago, so Wall Street changed their name. High-yield sounds a lot better than junk, doesn’t it?

Investors who worry about losing money in the stock market often fail to recognize that bond default risk is very real. Junk or “non-investment grade”  bonds have seen some serious default rates in the past, and with junk bond buying at record highs, the high-yield bond market could be the setting for our next financial disaster. The chart below shows the default rates of bonds by their credit ratings. This was compiled under the U.S. Municipal Bond Fairness Act of 2008.

Remember, bonds are supposed to be a safe haven for your net worth. If you want a real return that has historically outpaced inflation, you need to have the correct portion of your money in stocks. Though volatile, stocks have historically been the best way to get a good return on your long term investments. Be very wary of investing in any bonds rated below Baa/BBB by S&P or Moody’s. Stocks represent ownership in a company.  You would expect a reasonable rate of return over time and to benefit from their profits.  With junk bonds, you are lending your money to someone who is not very credit worthy. Is the risk really worth it?

Cumulative Historic Default Rates (in percent)

Moody’s S&P
Rating category Muni Corp Muni Corp
Aaa/AAA 0.00 0.52 0.00 0.60
Aa/AA 0.06 0.52 0.00 1.50
A/A 0.03 1.29 0.23 2.91
Baa/BBB 0.13 4.64 0.32 10.29
Ba/BB 2.65 19.12 1.74 29.93
B/B 11.86 43.34 8.48 53.72
Caa-C/CCC-C 16.58 69.18 44.81 69.19
Investment grade 0.07 2.09 0.20 4.14
Non-investment grade 4.29 31.37 7.37 42.35
All 0.10 9.70 0.29 12.98

Source: U.S. Municipal Bond Fairness Act, 2008. See also: Monevator.com, House Report 110-835

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