At a certain point, good old stocks and bonds might start to seem a little bit boring.
There has to be more out there, especially when you start to build up substantial wealth.
These other types of investments are often referred to as alternatives.
They sound much more exciting and exclusive than stocks and bonds, and are typically sold
as having higher potential returns or diversification benefits that plain old stocks and bonds can’t
offer.
As Warren Buffett explained in his 2016 letter to Berkshire Hathaway shareholders:
“In many aspects of life, indeed, wealth does command top-grade products or services.
For that reason, the financial “elites” – wealthy individuals, pension funds, college
endowments and the like – have great trouble meekly signing up for a financial product
or service that is available as well to people investing only a few thousand dollars.”
Alternative investments are a broad category, so I have split this topic up into multiple
parts.
I’m Ben Felix, Associate Portfolio Manager at PWL Capital.
In this episode of common sense investing I will tell you why you should think twice
about owning high yield bonds.
In our low-interest rate world, investors tend to seek out the opportunity to earn higher
income yields from their investments.
Two of the most common ways to do this are through high-yield bonds and preferred shares.
High yield bonds are riskier bonds with lower credit ratings and higher yields than their
safer counterparts.
Standard and Poors rates all bonds between AAA, the highest rating, and DD, the lowest
rating, based on the bond issuer’s ability to pay back their bond holders.
High yield bonds have a rating of BB or lower, defined by Standard and Poors as “less vulnerable
in the near-term but faces major ongoing uncertainties to adverse business, financial, and economic
conditions.”
Remember that you typically hold bonds in your portfolio for stability.
High yield bonds are too risky to serve this purpose.
In fact, a 2001 study by Elton, Gruber, and Agrawal found that the expected returns of
high yield bonds can mostly be explained by equity returns.
In other words, high yield bonds contain much of the same risk as stocks.
Only 3.4% of high yield bond issuers have historically been unable to pay back their
bond holders, but when they are unable to pay, bond holders have typically recovered
a little less than half of their investment.
It is true that, in isolation, high yield bonds have had high average returns in the
past.
However, including high yield bonds in portfolios has been less exciting.
In a 2015 blog post, Larry Swedroe compared four portfolios, one with all of its fixed
income invested only in safe 5-year treasury bonds, the other three with each an increasing
allocation to high yield corporate bonds.
He found that while the portfolios with high yield bonds did outperform by a narrow margin,
between 0.2 and 0.5 percent per year over the long-term, they did so with significantly
higher volatility than the portfolio containing only treasury bonds.
On a risk adjusted basis, the high yield bonds did not add value to the portfolio.
In Swedroe’s book The Only Guide to Alternative Investments You’ll Ever Need, he writes
“Investing in high-yield bonds offers the appeal of higher yields and the potential
for higher returns.
Unfortunately, the historical evidence is that investors have not been able to realize
greater risk-adjusted returns with this type of security.”
In his book Unconventional Success, David Swensen, the chief investment officer of the
Yale Endowment, similarly denounces the characteristics
of high yield bonds, writing that "Well-informed
investors avoid the no-win consequences of high-yield fixed-income investing."
On top of all of this, high yield bonds are tax-inefficient.
They pay relatively high coupons, which are fully taxable as income when they are received.
As an asset that behaves similar to stocks, high yield bonds are a very tax-inefficient
way to get equity-like exposure.
High yield bonds do have some proponents.
Rick Ferri, a well-respected evidence-based author and portfolio manager, does include
high yield bonds in his portfolios.
I do not recommend high yield bonds in the portfolios that I oversee.
If you do choose to include high yield bonds in your portfolio, they should only make up
a small portion of your fixed income holdings.
Due to the risk of default and relatively low recovery rate, it is also extremely important
to diversify broadly with a low-cost high-yield bond ETF.
I would never suggest purchasing individual high yield bonds.
Join me in my next video where I will tell you why preferred shares don’t get you any
preferential treatment.
My name is Ben Felix of PWL Capital and this is Common Sense Investing.
I’ll be talking about a lot more common sense investing topics in this series, so
subscribe and click the bell for updates.
I want these videos to help you to make smarter investment decisions, so feel free to send
me any topics that you would like me to cover.
My name is Ben Felix of PWL Capital and this is Common Sense Investing.
I’ll be talking about a lot more common sense investing topics in this series, so feel free to
send me future topics that you would like me to cover!