Dangers of High Yield Hunting

Fixed income investors that were accustomed to earning 5% on a portfolio of government bonds are now getting 2% for the same securities. The steep drop has interest starved investors hunting for yield. As usual, the easiest way to increase yield has been to increase risk, and investors have taken the path of least resistance.

Nowhere is this more prevalent than in the high yield bond market. According to Morningstar, high yield bonds saw the largest percentage-based inflows in 2012 among all the asset categories it tracks. In addition, high yield bond issuance reached an all-time high in 2012, reflecting record demand for the asset class.

It’s easy to see why, with 10 year Treasuries yielding less than 2%, a 6%+ yield can look pretty enticing. However, I think investors may be forgetting that high yield bonds are called “junk bonds” for a reason. Junk bonds got that name because of the poor credit quality of the issuers and/or the weak terms of the underlying covenants (with respect to investors). They pay high yields because they have a higher risk of default versus investment-grade bonds, it’s that simple.

With that in mind, high yield bonds are currently paying investors the lowest yields in absolute terms ever for taking on that risk. In relative terms as well, the 400 basis point spread to Treasuries is also below the long-term average of 600 basis points. The chart below shows junk bond yields from 1988 to 2012 based on the FINRA/Bloomberg Active U.S. High Yield Bond Index.

Some may say that the low yields reflect the fact that default rates in the high yield bond market have been very low. Sure, that may be true. However, I think abnormally low default rates are a terrible reason to be complacent. All else equal, below average default rates, come with the risk of rising defaults and should call for heightened vigilance.

A good time for high yield bonds would have been 2009 when absolute yields and relative spreads both exceeded 20%. Those looking for high yield in the current rate environment are hunting on dangerous grounds, in my opinion.

Victor K. Lai, CFA

This blog is for informational purposes only. Nothing on this blog constitutes investment, tax, or legal advice. You should conduct proper due diligence and / or consult with professional advisers before taking any investment action.