High-Yield Means High-Risk
Bond yields fell to record lows this year, but retirees and other investors must resist the temptation of high-yield bonds. Before the 2008 financial crisis, it was possible to earn over 4% per year with Treasury bills. Today, even 30-year Treasuries yield below 2.5%. Investment-grade corporate bonds often pay less than 3.5%. Just about the only way to get more than 4% is “high-yield” bonds, which is a polite term for junk bonds. The prospect of earning 5.5% a year or more in the bond market is certainly appealing. Unfortunately, we will see that it is too good to be true.
The recent run-up in bond prices makes high-yield more high-risk than usual. Junk bonds always have higher yields than investment grade bonds because of their higher default risk. Unfortunately, junk bond yields today are actually low by their own standards. Junk bonds gained more than 12% in the first ten months of 2019, pushing yields down. As the yield falls, bond investors lose a vital cushion against losses.
Make no mistake about it, there will be losses in the junk bond market. Unlike stocks and precious metals, which tend to rise in price over time, junk bond funds fall in price. For example, the junk bond ETF JNK was worth $108 per share in November of 2019 compared to $144 at the beginning of 2008. That isn’t just because of the 2008 financial crisis. The Vanguard High-Yield Corporate Fund is an exceptionally conservative junk bond fund, but the price fell from over $10 a share in 1979 to below $6 in 2019.
Junk bonds do make money, but all their profits come from high yields that are usually more than enough to make up for losses from defaults. What passes for “high-yield” today in the junk bond market probably isn’t nearly high enough. Many junk bond funds suffered terrifying price declines of 40% or more in 2008. Between 2014 and 2016, junk bond prices fell by over 20% without a recession in sight. A 5.5% yield is not worth taking that kind of risk. That’s why people call them junk.
Investors should try to boost their returns with quality alternatives instead of junk. Adding precious metals to bond holdings has historically improved performance and provided protection from inflation. For example, adding 10% gold to a portfolio of 10-year treasury bonds increased returns by 0.4% per year between 1971 and 2018.
Switching to a balanced allocation with equal amounts of gold, stocks, and Treasury bonds provides even greater benefits. This diversified portfolio had an average return of about 9.5% per year since America abandon the Gold Standard. That is far more than the 5.5% promised by junk bonds today. Maximum calendar year losses were less than 10%, which makes it safer too. Instead of reaching for yield with junk bonds, informed investors go for the gold when real interest rates are low.