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As the name implies, high-yield bonds are debt securities that offer extremely generous interest rates. The downside, of course, is that these bonds are issued by companies with less than stellar credit ratings. So to capture that higher yield, investors must also assume a higher degree of risk. That potential headache has frightened many investors away from the high-yield sector. However, at times this asset class can provide double-digit returns that rival those in the equity markets, with significantly less volatility -- and we could be headed for one of those periods. Don't Believe Everything You've Heard Don't make the mistake of thinking all high-yield bonds are "junk." The reputation of this group was tainted years ago with the high-profile securities fraud conviction of Michael Milken, who was instrumental in bringing these securities to prominence as a funding vehicle for hostile corporate takeovers and leveraged buyouts (LBOs). Because of this, many people assume high-yield bonds are only issued by shady businesses committing some sort of crime, but this isn't true. Fortunately, rating agencies like Moody's (NYSE: MCO) exist to help sort through the gaggle of bonds available. These companies evaluate each issuer's creditworthiness through a rigorous examination of its balance sheet, cash flow visibility and overall financial stability. The companies that score highest are deemed to be worthy of "investment grade" status ("Baa" or higher), while those with a few question marks are assigned ratings that fall on the lower rungs of the credit quality ladder. Additionally, the high-yield bond market has evolved since the famous scandal and is quite appealing today, thanks to several factors: Growing Global Market: According to Dealogic, global high-yield debt issuance totaled more than a quarter-trillion dollars in 2007, with volume reaching a record $100 billion in the second quarter alone. Much of that came from overseas markets, which now account for roughly half of new high-yield issues. Quality Issuers: While it's true that some high-yield debt really is junk, many companies with below investment-grade credit ratings are actually on sound financial footing and generate hefty cash flows. High-yield bond issuers include venerable firms like General Motors (NYSE: GM), Hilton Hotels and MGM Mirage (NYSE: MGM). These three companies are just a small sample of the numerous companies from a variety of industries issuing high-yield debt. Not Rate Sensitive: High-yield bonds typically have low durations and aren't particularly sensitive to interest rate fluctuations. Much like stocks, high-yield bond returns are driven more by the overall state of the economy -- which influences the ability of borrowers to meet their payment obligations. As a result, these bonds can actually gain ground in a rising rate environment, while others tend to struggle. This low correlation makes the high-yield sector a powerful diversification tool. Capital Appreciation Potential: High-yield bonds have delivered average annual returns of nearly +10% over the past five years -- not all of those gains have come from interest payments. It's not uncommon for these bonds to trade at steep discounts to their par value, paving the way for significant gains if the financial outlooks for the underlying companies show signs of improvement. For example, Standard & Poor's upgraded 193 high-yield issuers in 2005, boosting the value of more than $200 billion worth of debt. The Sky is Not Falling Having said all this, there is still no sugar coating the biggest risk faced by high-yield bond investors: the dreaded default. For some reason or another a company may deteriorate and won't be able to meet certain loan covenants or come up with the cash to cover its payments. While this risk is certainly real, it is often overstated and more than compensated for by the extra yield. In fact, at the end of January default rates sunk to around 0.9% -- the lowest rate in nearly 30 years. And according to the Bond Market Association, the yield spread (or "risk premium") between high-yield bonds and Treasury securities of comparable maturity has run between 300 and 400 basis points throughout most of the past two decades. In other words, if a 10-Year Treasury Bond offered a yield of 4%, then a corresponding high-yield bond might get you a much juicier payout of 7-8%. Thanks to the subprime meltdown, investors can now rake in yields more than 600 basis points above the rate on corresponding Treasuries. That is more than double the 2.7% differential from this past June and marks the highest interest spread since 2000.
Looking Ahead Good investing!
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