High-yield bond funds

[Willers]

I will be the first to admit to not being a bond expert so I've wondered about the use of high-yield bond funds. I believe that most investors include these as part of their bond allocation, but they seem to be very equity-like in their returns/behavior.

It seems that they have much of the down-side risk of equities (e.g. 2008) and similar upsides as well. In that case, wouldn't it be better to just invest more on the stock side? I feel like I'd be fooling myself into thinking I had a more bond-like allocation than I really did. I've always been more of a total return investor so income at the expense of all else hasn't been a driver for me.

I guess my question comes down to: how do you use them in your portfolios? What role do they play? I'm not for or against them; I feel like I'm not understanding their benefit. What am I missing?

Thanks!

 

[brewer12345]

High yield bonds can offer very attractive returns, but you must be opportunistic about this market. The "pool" of juunk bonds is not that big, so when the elephants get in or get out, te water sloshes around mightily. When they are dumping, you should be buying. Usually that means when spreads get to 900 or 1000 BP over treasuries. When they are buying greedily and foolishly, you should be selling. Usually taht means when spreads go below 500BP. Right now spreads are around 400 BP so I have been out of junk for a while. When this market goes to pieces again in the future, I will be standing there with a giant pile of cash and a greedy smile.

 

[foxfirev5]

Agreed with Brewer. Although I'm slowly lowering junk at this stage rather than dumping it all. Regardless I would not be adding any new.

 

[Cobra9777]

Currently, I've got about 20% of my fixed income allocation in high-yield corporate. That's higher than usual as a modest hedge against rising rates, which I think are inevitable as the economy improves. High-yield corporate bonds tend to hold up better than government and investment-grade corporate during such periods due to strong underlying business conditions, which presumably mitigate some of the credit risk. Regardless of the environment, I like the diversification benefits of high yield and low duration against an otherwise plain-vanilla, aggregate US bond portfolio. I also carry a small amount of international and municipal for diversification. I'm not crafty enough to outsmart the elephants like brewer.

 

[mathjak107]

on a comparative basis high yield bonds no longer offer the deal they once did and are the equal to the dow at 25,000 if you had to put a number on their values.

 

[marko]

I have about 10% in high yield bond funds. The price more closely follows the market rather than inversely to interest rates and a nice paycheck each month!

I've often struggled with the "allocation" (is it a bond or a stock?) and previous posters have offered that it is 'somewhere in between'...

 

[mathjak107]

with such a small spread between the treeasury and high yield they are way over valued. more so than stocks. the typical fund is in the 4%-4.50%
range.
i do like special situation high yield like fidelity capital and income which buys distressed stocks as well.

 

[target2019]

I will be the first to admit to not being a bond expert so I've wondered about the use of high-yield bond funds. I believe that most investors include these as part of their bond allocation, but they seem to be very equity-like in their returns/behavior.

It seems that they have much of the down-side risk of equities (e.g. 2008) and similar upsides as well. In that case, wouldn't it be better to just invest more on the stock side? I feel like I'd be fooling myself into thinking I had a more bond-like allocation than I really did. I've always been more of a total return investor so income at the expense of all else hasn't been a driver for me.

I guess my question comes down to: how do you use them in your portfolios? What role do they play? I'm not for or against them; I feel like I'm not understanding their benefit. What am I missing?

Thanks!

I have 2.38% Vanguard High-Yield Corporate Fund in my SEP-IRA. I re-allocated about 2% out of my Total Bond Market to that, 2-3 years ago. I did it to diversify my bond allocation. I may go to 5% overall allocation when I retire. HY bond funds vary quite a bit.

This TIAA-CREF paper explains the benefits:
The enduring case for high-yield bonds

 

[mathjak107]

I will be the first to admit to not being a bond expert so I've wondered about the use of high-yield bond funds. I believe that most investors include these as part of their bond allocation, but they seem to be very equity-like in their returns/behavior.

It seems that they have much of the down-side risk of equities (e.g. 2008) and similar upsides as well. In that case, wouldn't it be better to just invest more on the stock side? I feel like I'd be fooling myself into thinking I had a more bond-like allocation than I really did. I've always been more of a total return investor so income at the expense of all else hasn't been a driver for me.

I guess my question comes down to: how do you use them in your portfolios? What role do they play? I'm not for or against them; I feel like I'm not understanding their benefit. What am I missing?

Thanks!

i have a place for regular bonds but at this stage not really a place for high yield .

why do we have bonds in our portfolio ?

we have them because we want to maintain a certain range of volatility in our portfolio. we want a certain range so we can sleep at night when stocks fall as they always do. by maintaining a certain ratio of stocks to bonds if markets fall we can try to keep the losses in a range compared to 100% equities. .

well think about it. if we dumped all our bonds and moved to cash what would happen?

1: we would actually have a negative real return on our cash vs an even with inflation real return on bonds . you can lose 2% and still be no worse off .

but that isn't the real reason

2: the real reason is because bonds tend to move opposite stocks. when stocks tank bonds go up generally and we are not down overall as much.

well if we go to cash what do we have to do to maintain that same volatility swing in a downturn?

we have to sell stocks and hold more cash instead since cash does not produce capital gains . in fact in a bad downturn interest rates usually get cut .

you have to up your cash allocation at the expense of your stock allocations to maintain that same volatility swing .

If you were comfortable with a 50/50 mix of stocks and bonds you may have to go to a 40/60 or 35/65 mix of stocks and cash to get those swings back in line.

think about it, to keep your portfolio in the same volatility range you need to allocate more money to cash and tie it up at near zero than you would have to put in to bonds to accomplish the same volatility objective..

thats crazy, your stocks can go up so much more off-setting any drop in bond prices so why would you want to pull money out of your stocks to increase cash when less money in bonds protects you the same.

so what if bonds fall, the extra money still in stocks will make up most of that if not all of it and then some.

you can not use same allocation of stocks and cash as you had in stocks and bonds and expect the same swings in a downturn..

 

[Willers]

I have 2.38% Vanguard High-Yield Corporate Fund in my SEP-IRA. I re-allocated about 2% out of my Total Bond Market to that, 2-3 years ago. I did it to diversify my bond allocation. I may go to 5% overall allocation when I retire. HY bond funds vary quite a bit.

This TIAA-CREF paper explains the benefits:
The enduring case for high-yield bonds

Thanks for the link. Good information.

 

[scrabbler1]

Keep in mind that there is a wide range of bonds and bond funds which are below investment grade. I have a large amount of money in a Fidelity bond fund (Fidelity Focused High Income) which invests in bonds at the low end of investment grade (BBB) and the high end of below-investment grade (BB, B). I get a better rate of return than bond funds which invest in bonds only at least investment grade without having any significant amount in bonds with awful ratings such as C and D (or not rated).

 

[pb4uski]

The HY funds I use are ~75% B or better. CCC- is as low as they go.

 

[coldnose]

Another option, often overlooked, are funds that hold shares of preferred stock. These generally pay a somewhat higher yield (maybe 6-7%) without significant higher risk than bonds. Many (most?) of the companies issuing preferred stock are banks or utility companies.

Obviously, do your research but this could be an option if you are looking for a steady income stream.

 

[GrayHare]

2: the real reason is because bonds tend to move opposite stocks. when stocks tank bonds go up generally and we are not down overall as much.

Actually, long-term graphs show there is an inflection point at 5% on 10-year Treasuries. When the 10-year is below 5%, as it is currently, what you say is true: stock prices and bond prices tend to move oppositely. However when the 10-year is above 5%, stock and bond prices tend to move in the same direction.

 

[brewer12345]

Another option, often overlooked, are funds that hold shares of preferred stock. These generally pay a somewhat higher yield (maybe 6-7%) without significant higher risk than bonds. Many (most?) of the companies issuing preferred stock are banks or utility companies.

Obviously, do your research but this could be an option if you are looking for a steady income stream.

Extended duration, high negative convexity and significant credit risk all for 400 BP over treasuries: how could I lose?

Pass.

 

[target2019]

Thanks for the link. Good information.

Most welcome.
I noticed in the article that the spread was 400 bp in April 2013. The spread today is much narrower.

As you can tell from some of the responses, there is opposition to HY of any duration or grade. I don't believe there is a ready answer.

 

[mathjak107]

Actually, long-term graphs show there is an inflection point at 5% on 10-year Treasuries. When the 10-year is below 5%, as it is currently, what you say is true: stock prices and bond prices tend to move oppositely. However when the 10-year is above 5%, stock and bond prices tend to move in the same direction.

i saw some study on that fact but for the most part we need to protect for the below 5% level anyway at present.

 

[ERhoosier]

Extended duration, high negative convexity and significant credit risk all for 400 BP over treasuries: how could I lose?

Pass.

Agreed. Intermediate-to-long term HY bonds (or funds) do not look attractive to me now either.

 

[clifp]

Most welcome.
I noticed in the article that the spread was 400 bp in April 2013. The spread today is much narrower.

As you can tell from some of the responses, there is opposition to HY of any duration or grade. I don't believe there is a ready answer.

Looking at the TIAA-Cref paper it hardly makes a compelling case for high yields. When the economy trashes we expect stocks to crash, that is what they do. The reason stocks do better than bonds over the long term, is the economy picks up stocks do much better more than doubling, and this is just when the economy goes from awful to merely bad.

The paper points out that high yields have a negative correlation to treasuries the same as stocks. Despite what the paper says this is not a good thing for a retiree. When the economy is in the ****, as retiree we want an asset that we can sell A. for expenses and B. to give us some money to buy the cheap stocks out there. High Yield bonds are one of those things you want to buy when the financial market is in turmoil not in today's benign environment.

During the crash High Yields prices dropped almost as much as stocks. I ended up buy Vanguard high yield in Jan 2009.. I could have bought stocks instead, (and did) but the appeal of high yields at the time was two fold. First compared to other bonds they looked super attractive, and second the yield was 11-12%. I figured worse case 10% of the companies would go bankrupt/year and bond holders would get back 50% of their money. Subtracting the 5% principal loss from the current yield left me 6-7% in time when banks were slashing dividends along with a few other companies. Today with Vanguard High Yield only yielding 4.5%, you still face a potential (worse case loss) of 5% principal loss per year during the next great recession, but you have no upside.