Investors are piling into junk bonds. What to know before buying

Investors have been pouring money into high-yield bonds, which typically pay more to take on more risk. But these investments are also known as “junk bonds,” and financial experts urge caution before piling in.

After a rocky start to 2022, U.S. high-yield bond funds received an estimated $6.8 billion in net money in July, according to data from Morningstar Direct.

While interest rates have recently dropped to 7.29% per August 10, rates 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 default risk than their investment-grade counterparts because issuers may be less likely to cover interest payments and loans at maturity.

“It’s a shiny metal on Earth, but all shiny metals are not 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 can seem more like stocks on the downside.

If an investor feels strongly about buying high-yield bonds, he might suggest a smaller allocation—for example, 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 combat inflation, including the second consecutive rate hike of 0.75 percentage points in July. And these rate hikes may continue with annual inflation still at 8.5%.

At the margin, rising interest rates could make it harder for some bond issuers to cover their debt, especially those with maturing bonds that need to be refinanced, said Matthew Gelfand, a CFP and managing director of Tricolor Capital Advisors in Bethesda, Maryland.

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

Coupon rate ‘spread’ is slightly smaller than usual

When evaluating high-yield bonds, advisers can compare the “spread” in coupon rates between a junk bond and a less risky asset, such as US Treasurys. In general, the wider the spread, the more attractive high-yield bonds become.

With high-yield bonds that pay 7.29% per Aug. 10, an investor can receive $72.90 a year on a $1,000 par value bond, while the 7-year Treasury, which offers about 2.86%, yields $28.60 annually for the same $1,000 bond.

In this example, the yield spread is about 4.43 percentage points, giving 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 about 4.8 percentage points, according to Gelfand, making the slightly narrower spread less attractive.

But “there are a lot of moving parts in the high-yield bond market,” he added.

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