High-yield bonds, which normally provide higher interest rates in exchange for more risk, have seen an influx of investment capital. However, these assets are also referred to as “junk bonds,” and financial professionals advise caution before investing.
According to information from Morningstar Direct, U.S. high-yield bond funds received an estimated $6.8 billion in net money in July after having a difficult start to 2022.
According to the ICE Bank of America U.S. High-Yield Index, interest rates have lately decreased to 7.29% as of August 10, although they are still higher than the 4.42% earned at the beginning of January.
Junk bonds, however, often have a higher default risk than their investment-grade counterparts due to the possibility that issuers won’t be able to make their interest and loan payments by the maturity date.
“It’s a shiny metal on the ground, but all shiny metals are not gold,” said Charles Sachs, a certified financial adviser and the chief investment officer at Miami’s Kaufman Rossin Wealth.
Although some claim that the greater yields of junk bonds account for default risk, Sach warns that these assets may behave more like stocks in the event of a downturn.
If a potential investor has strong feelings about buying high-yield bonds, he can recommend a smaller commitment, like 3% to 5%. “Don’t think of it as a major food group within your portfolio,” he added.
High-yield bonds may be at risk when interest rates rise
The Federal Reserve has been actively combating inflation since March, notably by raising interest rates for a second straight month in July by 0.75 percentage points. And with annual inflation at at 8.5 percent, these rate increases might continue.
Rising interest rates may, on the whole, make it harder for some bond issuers to pay off their debt, particularly those who have bonds that are about to mature and need to refinance, according to Matthew Gelfand, a CFP and executive director of Tricolor Capital Advisors in Bethesda, Maryland.
“I think that investors and lenders will demand somewhat higher rates as a result,” He noted that the trend of rising interest rates might last for some time.
The “spread” on coupons is a little less than usual
Advisors may evaluate high-yield bonds by comparing the “spread” in coupon rates between a junk bond and a less hazardous asset, such as U.S. Treasurys. High-yield bonds typically become more appealing as the spread widens.
In comparison to the 7-year Treasury, which offers roughly 2.86% and pays $28.60 yearly for the same $1,000 bond, high-yield bonds pay 7.29% as of August 10 and can earn an investor $72.90 annually on a $1,000 face value bond.
According to Gelfand, the difference between these assets has typically been around 4.8 percentage points during the last 40 years, making the slightly smaller spread less desirable.
However, “there are a lot of moving parts in the high-yield bond market,” he added.