Extra Yield Means Extra Risk

Extra Yield Means Extra Risk

With interest rates at historic lows and likely to remain there for a couple of years, investors are searching for alternatives to bonds to provide some much-needed yield in their portfolios. As a result, dividend-paying stocks, real estate investment trusts (REITs), master limited partnerships (MLPs), and high-yield bonds have all succeeded in attracting investors’ attention and money as they provide above-market yields.

Dividend-paying stocks, REITs, and MLPs all represent shares of equity ownership, so we rarely witness confusion about the amount of risk involved in these types of securities within the marketplace. Equity ownership means equity-type risk when it comes to volatility and potential for loss, and investors seem to understand that.

On the other hand, we often find that investors underestimate the risk they are taking by investing in high-yield bonds. Because these securities are bonds, investors can and do make the incorrect assumption that investing high-yield bonds involves similar risk to investing in other types of bonds. Looking at history, that is definitely not the case.

While the risk statistics of high-yield bonds fall in between those of traditional bonds and stocks, they are much closer to stocks in terms of volatility and potential for loss. For example, in 2008, stocks as measured by the S&P 500 Index lost -37.0% while the bond market, as measured by the Barclays U.S. Aggregate Index gained 5.2% thanks to its high allocation to high-quality bonds. High-yield bonds—which have low credit quality by definition—declined -26.4% that year as measured by the Merrill Lynch High Yield Master II Index. And since September 1986, high-yield bonds have been much more correlated to stock price movements than bond price movements (0.58 to 0.24).

In closing, high-yield bonds are attractive right now due to low default rates, strong corporate balance sheets, and attractive credit spreads, but investors who are looking to the high-yield bond market for extra yield need to be aware of the extra risks.

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