Lower-rated bonds are again an issue. Know the risks.
When market conditions are as friendly as they have been for past decade, it is easy to lose sight of growing risks. One that I keep coming back to is the continued deterioration of the fabric of the global bond market. Whether it is foreign yields below zero, mounting government debt in the U.S., or a smokescreen in the high-yield bond corporate bond market, knowing the score can be a retirement-saver.
The latter issue is my latest warning to the complacent investors of the world. You see, things seem just right in the world of lower-rated bonds. They pay monster yields compared to U.S. Treasuries and higher-rated bonds. That has created chase for yield, since so much of the money in that market is run by big institutions and hedge funds. Competition in that field is high, and one of the biggest risks those managers take is to lag this long bull market.
That allows some very “junky” bonds to stay afloat longer than they should. At some point, confidence breaks. Then, you get something akin to what we had during the Financial Crisis last decade.
I don’t know how close we are to a repeat implosion of bonds from companies with weak credit. But the energy and retail sectors are already showing cracks. It’s tough to make a profit drilling for oil at current oil prices. And, it’s tough to sell anything through a “traditional” retail system. Yet somehow, as the chart below shows, bonds in the CCC-rating category (BB is the highest-rated junk segment, then B, then CCC) are hinting that the glory days for risky bonds are nearing an end.
The chart above shows that the “spread,” which is the gap between yields of CCC bonds and B–rated bonds are climbing. They are around their October, 2008, level. The spread is about 7%.
Now, a 7% higher yield in CCC bonds versus B bonds is not the end of the world as we know it. But it is yet another trend to add to the pile of market indicators
that suggest to investors that future returns will not match the recent past.
What you don’t know may hurt you
The bigger issue is for investors who don’t realize that they own some of these deteriorating securities in their portfolio. They know they own a “high yield bond fund” in their 401(k) or an account managed by an advisor. However, it might not be obvious by the fund’s name. Some funds that include in their name things like “high income” and “multi-strategy” may sound like they are full of high quality securities.
However, I identified several in my research that have 20-40% of their assets in bonds rated below B. And, when you combine that with the number of “unrated” bonds in some of those funds, you either have a big yield you can take to the proverbial bank, or an accident waiting to happen when credit markets tighten again.
High (yield) anxiety? Not if you do this.
The bottom line for you and your portfolio: high yield funds don’t yield more simply because the manager is an expert at squeezing more yield out of their investments than mere mortals. They do know their stuff. However, no matter how sharp a bond manager is, they have no place to hide when the junk eventually hits the fan.
Therefore, it behooves every investor to be aware of these types of potholes among their fund holdings. Finding this information is easy enough. Mutual funds typically disclose their holdings every month. Most ETFs do so every day.
So, ignorance is not an excuse. Know what you own, and make sure it is in sync with what you are trying to get out of your investment portfolio
Related: Why Your Stock Portfolio Is Performing Worse Than The S&P 500 Index