Junk Bonds: Is It Time To Buy?
Often misunderstood and frequently labeled as too risky, junk bonds may actually offer a strategic entry point for newer investors seeking higher yields in today’s uncertain market.
With interest rates stabilizing and risk appetite returning, high-yield debt is drawing renewed attention – and it’s time to examine whether its reputation still fits the reality.
What Exactly Are Junk Bonds, And How Do They Differ From Investment-Grade Bonds?
Junk bonds are corporate debt securities rated sub-BBB- by credit agencies.
They offer higher yields than investment-grade bonds to compensate for their higher credit risk (i.e., higher risk of default).
Why Might Junk Bonds Appeal To Newer Investors Despite Their Risky Reputation?
Junk bonds commonly provide 6-10% annual yields compared to 2-4% from safer bonds.
This can be appealing to investors of all levels of experience searching for higher returns.
Also, in low-interest rate environments, government yields are low (the baseline yield that all financial assets are priced off of), which incentivizes investors to take on more equity or credit risk to hit their return targets.
Are There Common Misconceptions That Unfairly Deter First-Time Investors From Considering Junk Bonds?
It’s sometimes assumed that junk bonds are too risky. But most pay their obligations and are issued by still-functional companies.
BB-rated bonds (i.e., just below investment grade) have historically low default rates of around 2% annually.
And the diversification effect is probably overemphasized. Junk bonds have the same environmental bias as equities (when economic growth is solid and tame inflation) and have shared around a +0.74 correlation to equities historically (using the SPY and HYG ETFs).
What Are The Key Upsides And Potential Risks Of Including Junk Bonds In A Starter Portfolio?
Upsides to junk bonds include higher income potential compared to safer bonds.
Risks include principal loss from defaults, increased volatility and capital losses during economic downturns and drops in the broader market, and liquidity challenges during market stress.
Are Junk Bond ETFs Preferable For Beginners Compared To Buying Individual Bonds?
ETFs provide easy diversification across hundreds of bonds and daily liquidity.
This makes them far more suitable than trying to analyze high-yield issuers individually and having more idiosyncratic exposure.
In What Sectors Or Market Conditions Do Junk Bonds Tend To Perform Better?
Junk bonds typically outperform during economic recoveries, stable growth periods, or when interest rates are stable or falling (relative to what’s discounted).
The energy, telecom, and retail sectors historically comprise large portions of the high-yield market (i.e., “old economy” sectors)
How Can Junk Bonds Help Diversify Or Enhance Yield In Today’s Market?
You could say they offer a bit of a middle ground between stocks and investment-grade bonds.
They can boost portfolio income while maintaining lower volatility than equities. Junk bond ETFs typically have around two-thirds the volatility of the S&P 500 and half that of the NASDAQ. They tend to have higher coupons than investment-grade bonds.
My Advice For Risk-Averse Investors Who Are Curious About High-Yield Bonds
Start small with a diversified high-yield ETF allocation of 5-10% of your portfolio (e.g., HYG or JNK).
Focus on higher-quality BB-rated funds, and be prepared to hold through all market/economic environments to capture the yield premium.
Avoid chasing the highest yields and focus on total return and credit quality.
The information provided in this article is for informational purposes only and does not constitute financial advice, investment recommendations, or an offer to buy or sell any securities. Always conduct your own research before making any investment decisions.