Investors have been pouring money into high yield bonds, often paying more interest when taking on greater risk. But these investments are also known as “junk bonds,” and financial experts advise caution before pouring money into them.
After a rough start to 2022, US high-yield bond funds received an estimated $6.8 billion in net money in July, according to data from Morningstar Direct.
While the yield has recently dropped to 7.29% As of August 10, interest rates are still higher than the 4.42% received in early January, according to the ICE Bank US High Productivity Index.
However, junk bonds typically carry a greater risk of default than their investment-grade bonds because the issuer may be less able to cover interest payments and loans before the maturity date. expire.
“It’s a shiny metal on the ground, but all shiny metals aren’t gold,” said certified financial planner Charles Sachs, chief investment officer at Kaufman Rossin Wealth in Miami.
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While some say default risk is built into the higher yields of junk bonds, Sach warns these assets could perform more like stocks in terms of downside.
If an investor feels strongly about buying a high-yield bond, he may suggest a smaller allocation – 3% to 5%, for example. “Don’t think of it as a staple food group in your portfolio,” he adds.
Since March, the Federal Reserve has taken aggressive actions to combat inflation, including 0.75 percentage points for a second straight interest rate hike in July. And interest rate hikes may continue with annual inflation remains at 8.5%.
Matthew Gelfand, CFP and managing director of Tricolor Capital Advisors in Bethesda, Maryland, says at the margin, rising interest rates could make it harder for some bond issuers to service their debt, especially those companies whose bonds mature need to be refinanced.
“I think investors and lenders will demand a little bit more interest rates,” he said, noting that rate hikes could continue for some time.
When evaluating high-yield bonds, advisors can compare the coupon interest “spread” between junk bonds and less risky assets, such as US Treasuries. In general, the wider the spread, the more attractive a high-yield bond becomes.
With high yield bonds payment 7.29% as of August 10, investors can receive $72.90 per year on a $1,000 denomination bond, while Treasury 7 yearsoffers about 2.86%, offering $28.60 annually for the same $1,000 bond.
In this example, the yield differential is about 4.43 percentage points, providing a so-called income premium of $44.30, which is $72.90 from the high-yield bond minus $28.60 from the Treasury.
Over the past 40 years, the average spread between these assets has been about 4.8 percentage points, according to Gelfand, making the narrower spreads a little less attractive.
However, “there are a lot of moving parts in the high-yield bond market,” he added.