High-yield bonds: Oasis or mirage for investment success?

The landscape for income investors is so barren it might as well be a desert. There are a few investment areas that look lush and fertile by comparison, but watch out: What looks like an oasis might turn out to be a mirage.

Those tempting-looking areas of the income landscape are high-yield bonds. Look carefully before you go that way though, because if you don't understand the potential dangers you may wish you had stuck to the territory of risk-free income.

High yield bond risks vs. reward

High-yield bonds are associated with a significant chance of default. To compensate for this risk, investors demand higher yields.

In recent months, the yield on U.S. corporate high-yield bonds has soared above 9 percent. That's a tempting yield, compared with Treasury yields of around 2 percent and investment-grade corporate yields of around 3 percent. The question is, does that additional yield provide investors with sufficient incentive to compensate for the greater default risk?

It's a given that some high-yield bonds will default. As an investor, the crucial question is which percentage of your high-yield bonds will go bad, and then how much of their value you can recover when they do. When you quantify the risk in that way, the math involved suggests the extra yield might be worth it at the moment, as detailed below.

Current yield vs. default rates

The default rate on those bonds yielding around 9 percent is currently 2.77 percent. So, if you had 2.77 percent of your bond portfolio go bad, you'd still be left with an effective return of 6.23 percent (the 9 percent yield minus the default rate.) While 6.23 percent sounds pretty good by today's standards, you'd actually do a little better if the default rate held steady.

Investors typically recover 40 percent of the value of defaulted bonds, so your actual losses would amount to just 60 percent of that 2.77 percent default rate, which comes to 1.66 percent. Subtracting that from 9 percent would leave you with a net of 7.34 percent.

Stress-testing the numbers

The above numbers are fine, but what if the default rate worsened? That would be a probable outcome during a recession, and even more so during a financial crisis.

Current default rates are well below the historical average of 4.3 percent. If default rates returned to 4.3 percent, and assuming a 40 percent default recovery rate, the net return on bonds yielding 9 percent would be reduced to 6.42 percent. That's still not bad, but during adverse circumstances default rates can soar into the double-digit range.

At a 40 percent recovery rate, a 10 percent default rate would reduce the net return on a bond at a 9 percent yield to just 3 percent. Effectively, that would leave you no better off than if you had remained in lower-risk investments.

Diversification becomes crucial

If you compare current yields with default rates and decide that you like the odds, there is one more factor to consider - diversification. The numbers work if your portfolio is broadly enough diversified for default rates to normalize. If you have just one or two bonds, a default in one or both of them would be devastating. The catch here is it is difficult to assemble a diversified portfolio without some management and trading costs, which would further reduce your net return.

No guarantees

Working through the math is a sensible way to compare default risk to yield, but you have to keep the exercise in perspective. There are no guarantees that historical norms will apply. If default risks exceed previous highs or recovery rates sink below normal, your return could be drastically less than you had calculated.

There are structural concerns to consider, and these concerns might go beyond the normal math of comparing yields with default frequency and severity. The low interest rate environment strongly encourages investors to look for higher-yield opportunities, which will help risky investments to attract money they otherwise wouldn't. In essence, this rewards or at least supports unsound bond issuers.

Similarly, the low interest rate environment discourages savings and encourages borrowing, which may be a poisonous prescription for a world that has been staggering from one debt crisis to another for nearly a decade now. This also makes investing in debt securities all the riskier.

In short, the math is saying that high-yield bonds may be worth the risk, but a common-sense read of the bigger picture says to keep those investments limited. No matter how good they look, to some extent the opportunity may be a mirage.

Comment: Do you invest in high-yield bonds?

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