Investors pile into junk bonds. What you should know before buying

Investors have poured money into high-yield bonds, which typically pay more interest when they take on more risk. But these investments are also known as “junk bonds,” and financial experts advise caution before piling up.

After a bumpy 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 have returns recently dropped to 7.29% Interest rates as of August 10 are still higher than the 4.42% received in early January, according to the ICE Bank of America US High Yield Index.

However, junk bonds typically have a higher risk of default than their investment-grade counterparts because issuers may be less likely to meet interest payments and loans to maturity.

“There’s shiny metal on the floor, but not all shiny metal is 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 junk bonds’ higher yields, Sach cautions that these assets could behave more like stocks on the downside.

If an investor is desperate to buy high-yield bonds, they can suggest a smaller allocation – say 3% to 5%. “Don’t think of it as a big food group in your portfolio,” he added.

Rising interest rates can be risky for high yield bonds

Since March, the Federal Reserve has taken aggressive measures to fight inflation, including a second straight 0.75 percentage point increase Rate hike in July. And those rate hikes could continue with annual inflation still hovering at 8.5%.

On the other hand, rising interest rates could make it harder for some bond issuers to pay off their debts, particularly those with maturing bonds that need refinancing, said Matthew Gelfand, CFP and executive director of Tricolor Capital Advisors in Bethesda, Maryland.

“I think investors and lenders will demand slightly higher interest rates as a result,” he said, noting that rising interest rates could continue for a while.

The coupon rate “Spread” is slightly smaller than usual

When evaluating high yield bonds, advisors can compare the “spread” in coupon rates between a junk bond and a less risky asset like US Treasuries. In general, the wider the spread, the more attractive high yield bonds become.

With high-yield bonds pay 7.29% As of August 10, an investor can get $72.90 a year on a $1,000 par bond, while the 7-year Treasury, which is offering about 2.86%, is $28.60 a year on the same $1,000 bond. dollar bond provides.

In this example, the yield spread is approximately 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 around 4.8 percentage points, according to Gelfand, making the slightly tighter spread less attractive.

“However, there are many moving parts in the high yield bond market,” he added.

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