Tahoe-Truckee Market Beat: The high-yield bond market
June 22, 2015
In last week's column I wrote about the highly anticipated interest rate increase by the Federal Reserve.
I discussed how equity markets have typically reacted favorably to rate increases after an initial pullback and how bonds are sensitive to changes in interest rates.
We measure bonds' sensitivity to interest rates by a mathematical formula known as duration. The higher the duration, the more sensitive your bond will be to increasing interest rates.
That being said, it is worth noting that all bonds do not behave the same. High yield or junk bonds can behave quite differently from investment grade bonds.
High yield bonds are below investment grade. There are three major rating agencies that rate bonds, and there are some slight differences in how the ratings are given.
Standard and Poor's and Fitch use ratings of BBB through AAA for investment grade.
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Moody's is similar, but uses Baa through Aaa. Bonds rated below BBB or Baa are considered high yield or junk bonds.
High yield bonds typically have a low correlation to investment grade bonds and are positively correlated to equity markets, which means that adding high yield bonds to your portfolio can increase diversification.
Many high yield bonds have a low duration, which means that they are not as sensitive to changes in interest rates. One reason they can have a low duration is because they are often issued with relatively short maturity dates.
Right now our economy has been fairly strong and the Fed will only raise rates if the data continues to show signs of economic strength.
Bear markets in stocks occur during times of recession. High yield bonds are similar to stocks, in that they tend to perform well when the economy is strong.
When investing in the high yield market, you need to be cautious about defaults.
Default rates are normally pretty low when the economy is healthy, but can spike during recessions.
High yield bonds are rated BB through D or Ba through C. The lower the rating, the higher the default risk.
There are a few simple ways to manage risk in high yield bonds. One is to diversify your holdings; it may make sense to use a mutual fund with an experienced manager.
Pay attention to the credit ratings, stick to the higher rated bonds and know what your duration is.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.