Why You Should Think Twice about High Yield Bonds | Common Sense Investing

At a certain point, good old stocks and bonds
might start to seem a little bit boring. There has to be more out there, especially
when you start to build up substantial wealth. These other types of investments are often
referred to as alternatives. They sound much more exciting and exclusive
than stocks and bonds, and are typically sold as having higher potential returns or diversification
benefits that plain old stocks and bonds can’t offer. As Warren Buffett explained in his 2016 letter
to Berkshire Hathaway shareholders: “In many aspects of life, indeed, wealth
does command top-grade products or services. For that reason, the financial “elites”
– wealthy individuals, pension funds, college endowments and the like – have great trouble
meekly signing up for a financial product or service that is available as well to people
investing only a few thousand dollars.” Alternative investments are a broad category,
so I have split this topic up into multiple parts. I’m Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of common sense investing
I will tell you why you should think twice about owning high yield bonds. In our low-interest rate world, investors
tend to seek out the opportunity to earn higher income yields from their investments. Two of the most common ways to do this are
through high-yield bonds and preferred shares. High yield bonds are riskier bonds with lower
credit ratings and higher yields than their safer counterparts. Standard and Poors rates all bonds between
AAA, the highest rating, and DD, the lowest rating, based on the bond issuer’s ability
to pay back their bond holders. High yield bonds have a rating of BB or lower,
defined by Standard and Poors as “less vulnerable in the near-term but faces major ongoing uncertainties
to adverse business, financial, and economic conditions.” Remember that you typically hold bonds in
your portfolio for stability. High yield bonds are too risky to serve this
purpose. In fact, a 2001 study by Elton, Gruber, and
Agrawal found that the expected returns of high yield bonds can mostly be explained by
equity returns. In other words, high yield bonds contain much
of the same risk as stocks. Only 3.4% of high yield bond issuers have
historically been unable to pay back their bond holders, but when they are unable to
pay, bond holders have typically recovered a little less than half of their investment. It is true that, in isolation, high yield
bonds have had high average returns in the past. However, including high yield bonds in portfolios
has been less exciting. In a 2015 blog post, Larry Swedroe compared
four portfolios, one with all of its fixed income invested only in safe 5-year treasury
bonds, the other three with each an increasing allocation to high yield corporate bonds. He found that while the portfolios with high
yield bonds did outperform by a narrow margin, between 0.2 and 0.5 percent per year over
the long-term, they did so with significantly higher volatility than the portfolio containing
only treasury bonds. On a risk adjusted basis, the high yield bonds
did not add value to the portfolio. In Swedroe’s book The Only Guide to Alternative
Investments You’ll Ever Need, he writes “Investing in high-yield bonds offers the
appeal of higher yields and the potential for higher returns. Unfortunately, the historical evidence is
that investors have not been able to realize greater risk-adjusted returns with this type
of security.” In his book Unconventional Success, David
Swensen, the chief investment officer of the Yale Endowment, similarly denounces the characteristics of high yield bonds, writing that “Well-informed investors avoid the no-win consequences of
high-yield fixed-income investing.” On top of all of this, high yield bonds are
tax-inefficient. They pay relatively high coupons, which are
fully taxable as income when they are received. As an asset that behaves similar to stocks,
high yield bonds are a very tax-inefficient way to get equity-like exposure. High yield bonds do have some proponents. Rick Ferri, a well-respected evidence-based
author and portfolio manager, does include high yield bonds in his portfolios. I do not recommend high yield bonds in the
portfolios that I oversee. If you do choose to include high yield bonds
in your portfolio, they should only make up a small portion of your fixed income holdings. Due to the risk of default and relatively
low recovery rate, it is also extremely important to diversify broadly with a low-cost high-yield
bond ETF. I would never suggest purchasing individual
high yield bonds. Join me in my next video where I will tell
you why preferred shares don’t get you any preferential treatment. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking about a lot more common
sense investing topics in this series, so subscribe and click the bell for updates. I want these videos to help you to make smarter
investment decisions, so feel free to send me any topics that you would like me to cover. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking about a lot more common
sense investing topics in this series, so feel free to send me future topics that you would like me to cover!

28 Replies to “Why You Should Think Twice about High Yield Bonds | Common Sense Investing

  1. Thanks Ben for these videos. Can you please cover percentage portfolio allocation in bonds and stocks by individual's age and risk factor.

  2. Thank you for the great video! Excellent production values and insights! Question – in Larry Swedroe's "The Only Guide to Alternative Investments You'll Ever Need" he mentions commodity futures as a great way to diversify from stocks and bonds, but every fund/ETF I've seen that specializes in commodities has an ER of 0.6% or higher – it strikes me as too expensive even if commodities do have a low correlation to stocks and bonds. Are commodity futures worth their expense?

  3. Good points. High yield bonds do reasonably well long term, but they are nearly as volatile as stocks. The only place I slightly disagree with the Ben, is that I have found well chosen actively managed funds to perform better than HY index funds, but YMMV. They can boost income a bit, but are a bumpy ride and should only be a small part of a balanced portfolio and definitely not something for a new investor.

  4. Vanguard has a High Yield (Junk) fund that looks pretty good. Wellington Investments provides Vanguard with a purchase list. There about 400 different names in this fund. The real good news is that these bonds drop in value like stocks in a panic. This creates a big sale on high quality, high yield bonds.

  5. You should think of them as stocks with a very high dividend. They will drop in value, creating a big buying oppertunity, but the dividend (Interest) is very high and very steady. Even if they are in a slumped market. This works very well for retired people who live off the income and let their account balance bounce around. When stock rebound so will the value of these bonds.

  6. They when you pass and someone inherits this fund, they can have the income and let the balance bounce with the market.

  7. This fund has a average coupon of about 6%. If you buy in a big bust, which we are overdue for, someone could lock in a 10% yield because you bough the shares at a fire sale.

  8. I am saying that the funds tendency to drop in price in a stock market panic is an oppertunity to buy Wellington approved high quality junk bonds. This is an advantage on a negative.

  9. These are not a good counter balance to stocks. They should be considered stocks that pay a very high dividend/interest while you wait for the market to rebound.

  10. Can someone make a video about how to use ytm to find out how much I'll make at maturity? Is ytm annual yield or total yield? I'm trying to buy a bond,but don't want to pay anything if I don't know how much I'll expect to make… Ameritrade doesn't show any calculating tool that can tell me how much I'll make. I don't mean I'll make this or that percentage ytm fnplsndk, I mean cash$ amount.

  11. Higher yield bonds are riskier than stocks and why anyone owns bonds
    any more is a mystery to me-bonds haven't made sense for the past 30 years.

  12. The only stock indices that have consistently beaten HY bonds are the US stock indices, and even they needed a stretch of 10 years without a major bear market. If one waited for XIU, the oldest TSX Index ETF, since 1 Jun 2007, 12 years ago, to beat HY bonds, he'd still be waiting!

  13. Hey Ben, thanks for the vid. Question: I'm 26 and already starting to invest a small amount of money. I know that my portfolio should be very aggressive overall. If I'm a super long-term investor (my retirement is very far away) then risk is not much of a concern for me, correct? So should I look into high-yield bonds in this situation? Thanks!

  14. While I do not invest in high yield corporate bonds, I have decided to overweight emerging market external bonds in my portfolio. This decision is based on:
    Dehn, Jan (2019): ” The Case for EM External Debt”; (Ashmore Group); https://www.advisorperspectives.com/commentaries/2019/06/04/the-case-for-em-external-debt?bt_ee=XXFEdaYgUUf1sUPacrvSx8p5xD1HTWR1Mg0qjOe6GF%2F2kjsKTZGenHv22ZProqnM&bt_ts=1559764204623

  15. Ben,

    What are your feelings on high yield municipal bonds?
    in terms of indexes
    From what i can tell they offer less risk, being backed by government entities, and similar returns.

  16. Ben, how do you feel about Vanguard VWEHX? Out of many junk bond mutual funds, it seems to be among the least risky.

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