Is There Any Life Remaining in the High Yield Debt Party?

Scott Moser, CPA/PFS, MST 

Last month we covered our concerns regarding current bank deposit yields and some possible alternatives.  This month,  our focus is on current opportunities in the high-yield bond market.  High yield bonds are composed of debt securities rated below investment grade.  The yield spread on high yield bonds are about 6% higher than Treasury bonds.  So investors receive a return that is 2 -  3 times higher for holding high yield debt compared to U.S. Treasury debt.  That additional return represents a risk premium investors demand to assume the potential risk of loss high yield investors may incur should the bonds decrease in value. Risk of loss is primarily driven by expected bond issuer defaults.  The chart below demonstrates that high yield bonds declined in value by more than 40% during the period 2006-2008.  Investors who sold in December 2008 likely realized a huge loss but those that continued to hold their positions into 2010 likely earned a 6% premium over Treasury bonds throughout the market turmoil. 

Investors with a long-term perspective and nerves of steel should be generously rewarded for holding high yield debt.  Aside from the downside volatility, high yield bonds tend to move with equity markets so they are not a good hedge against a correction in stocks.  Nonetheless, investors should consider high yield bonds in the following situations:  (1) they have a long-term investment horizon, dollars can be parked for 5 ? 10 years; (2) expect interest rates will rise,  high yield bonds are not as sensitive to increases in interest rates as Treasury bonds;  (3) expect a long-term sideways equity market, high yield bonds are more likely to outperform other alternatives in a low interest rate environment where stocks are lethargic. 

Caution-   Before you consider dipping into the high yield market,  consult with your investment advisor to sure they are appropriate in your circumstances and that you are prepared for the inevitable pot holes that surface.  Investors can lose 40% or more of their investment principal and there are no guarantees!