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How to understand high yield/junk bonds

The high yield fixed income market, also known as “junk bonds” is often one of the most misunderstood asset classes by many investors.   In recent years with interest rates at historically low levels, many investors have attempted to look at different investments to enhance the cash flow generated from their portfolio.   One such area has been the high yield marketplace.

High yield bonds by definition are bonds that pay a coupon (interest payment) in excess of the normal interest rate environment as a result of their lower credit quality.  They are typically below investment grade debt instruments.  There are several different rating agencies that rate fixed income credit quality. One such agency is Standard & Poors (S&P).  S&P ratings indicate any fixed income position with a rating below BBB is classified as below investment grade or “junk” status.

The term “junk” can sound quite derogatory in nature, and may insinuate that it is something to stay away from.  This is not necessarily the case. There is almost always a place for lower quality fixed income within the confines of a longer term investment plan. The first thing to understand is how high yield bonds correlate to other assets.  Most fixed income investments are inversely correlated to interest rates.  That means that when interest rates are rising, an existing bond offering a lower interest rate declines in value.  The relationship here is simple to understand. Imagine that you hold a bond issued by a corporation that matures in 10 years and pays 5%.  If rates rise to the point that the 5 year treasury pays 6%, why would anyone want to buy your bond paying 5% when they have to wait twice as long to get their investment back?  The answer is that they likely wouldn’t.  As a result, if you attempted to sell your bond early, it would sell at a discount (loss) from your original purchase, if you bought it as a new issue.  This is known as interest rate risk.

Joe Favorito

Joseph Favorito is a Certified Financial Planner™ who began his career in the financial services field in 1997. Over the past two decades Joseph has worked for several New York stock exchange members. In 2011 he founded Landmark Wealth Management, LLC , a Long Island-based Securities Exchange Commission registered investment advisory firm.