High Yield Bonds: Little Sense

This blog is an extract from the upcoming TopFund Guide.  It is obviously significant for high yield bond fund holders.  Those in strategic bond funds should also be wary, as a large proportion of high yield bonds reside in such funds. Plus it is important to understand how a collapse in this sector would threaten global markets of all kinds.

 

 

Bonds should be a straightforward lower risk investment. Bonds are a loan. You give me your money, I pay you a certain amount of interest each year for a fixed number of years, and then I give you your original money back.  But this is far from straightforward.

 

The quality of the borrower dictates the interest paid, the yield.  The higher the yield, the lower the assumed quality of the borrower i.e. the greater the likelihood that they will not pay the interest or repay the loan at the end of the term.

 

High yield bonds are therefore, by definition, the lowest quality bonds. There are two issues to highlight which are of immediate concern.

 

Firstly take a look at the chart .  You can see very clearly that when the high yield bond cycle turns down the yields head north of 20%.  With yields currently 4.6%, this implies massive falls in the capital value when the worm turns - we just don’t know when.  We previously highlighted that the risks of very sharp falls have been exacerbated by the rush into ETFs investing in this area. The rush for the exit will be ugly.

 

 

The second point more vividly illustrates a mania, or at the very least irrational behaviour.  European high yield bonds (what were more typically called “junk bonds” in the old days) now have the same yield as US government bonds.  That’s crazy.

 

Such bonds are issued by companies where the risk of going bust is noticeably higher than a more established business, with substantial profits.   

 

That the yields on these two very different types of bonds are the same suggest that the risks of one of these fringe companies going bust (and they do regularly) is the same as the US government going bust (which it never has).

 

Be very wary.