High-Yield Bonds…Junk or Treasure? (S3 E5)

Transcript

We’ve all heard the phrase, “Beauty is in the eye of the beholder,” and while this can be used in all kinds of circumstances, when it comes to investing, I think it is the perfect way to describe high-yield bonds. Many investors and financial professionals ignore this asset class because the perception is high-yield bonds tend to have stock-like risk with lower returns. While I acknowledge there is some truth to this perception, this episode will give you an opportunity to ponder how one person’s junk, may be another person’s treasure.

Welcome to the third season of Invested Poorly: Sad Tales of FInancial Fails, now part of the Bold Departure Network. Invested Poorly is a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with the show.

If you haven’t already listened to Episode 4 from Season 3, I would encourage you to do so before diving into this one because you need to have a decent understanding of the bond market and how bonds work to get the most out of it. With that caveat out of the way, let’s jump right in and start the discussion of whether or not high-yield bonds, sometimes referred to as junk bonds, deserve a spot in your portfolio.

My experience with junk bonds began early in my career as a portfolio manager. I was at a speaking event when an older gentleman came up to me after my presentation. I’m guessing he was in his early 70s and he started talking about all kinds of stock investments he had. He was fully retired, living off his investments and at some point in the conversation I asked him how much of his portfolio he had in bonds. He emphatically said zero, zilch, nada!!

I was like, WOW, are you crazy!?! Obviously I didn’t say this to him, but in my head I was thinking this guy is nuts. I mean at that point in time, the stock market had been doing extremely well for years and when this happens you always run across emboldened investors who think the good times will never end. I’m pretty sure I just made a casual comment, probably something like, “…that seems a little risky if you ask me.” He laughed, and pointed out that along with his 100% stock portfolio, he also had over three years of cash stored up to help balance things out.

I never forgot that conversation, and for years it stuck with me because in the back of my mind I was thinking, maybe this guy was on to something. He clearly understood that he needed to have a contingency plan in case stocks dropped sharply and he didn’t want to sell. Undoubtedly, this is where the cash came in and he figured he could wait it out for three years before ever being forced to sell his stocks.

As I said, it was early in my career when this happened, and I was just learning about safe withdrawal rates and how to spend money post FI. I had seen the data indicating that although bear markets typically only last a year or two, the recovery to new highs can take much, much longer. Thus, as interesting as his strategy sounded, it would still expose him to more risk than he was probably aware of. This is why most financial advisors recommend allocating a meaningful portion of your portfolio to bonds. They are supposed to serve as a buffer during the downturns, or so the theory goes.

Now, I’m going to be flat-out honest. My experience as a financial advisor for over two decades didn’t really match this expected outcome most of the time. In fact, despite that I recommended bonds for the same purpose every other financial advisor does, internally I was questioning the value of them because they always seemed difficult to explain to clients. In most years they underperform the stock market, and even in down years for the stock market, bonds can sometimes generate only small gains, or even losses. Over time, I became just as frustrated as many of my clients because it seemed to me the lower return profile of bonds didn’t seem to justify the small amount of portfolio protection they offered.

This frustration eventually led me to start investigating high-yield bonds, which initially should sound insane because, as I mentioned at the outset of this episode, the perception is that high-yield bonds offer stock-like risk in the short-term, with lower returns over the long-term. I mean, who would ever want to invest in something like that? Nevertheless, I kept digging.

I started my research devouring all kinds of data, but the “aha moment” for me came when I spoke directly to a high-yield bond portfolio manager. We spent well over an hour talking about the strategy, but the most memorable part of the conversation came when I asked him for the average maturity of the bonds in his portfolio, to gauge interest rate risk. He pretty much laughed at me and said, “Does it matter?” I was taken aback because I thought this was a legitimate question. He said, look, maturity doesn’t mean anything with high-yield bonds because they almost always get refinanced.

I didn’t fully understand what he was implying, so I asked him to enlighten me. He said that over the past couple of decades investment bankers have become more aware of how dangerous it is for higher risk companies to issue debt when market conditions are not good. Thus, the investment banks put a lot of pressure on companies with below-investment grade credit ratings to consider refinancing whenever they have a bond issue that is due in less than three years, assuming market conditions are favorable. So, most companies refinance well before their bonds mature.

However, if conditions are not favorable, they are now aggressively watching the market for the next three years, to make sure they do refinance when conditions improve. This, he suggested, is why default rates have plummeted within the high-yield bond sector. I remember thinking, wow, that makes so much sense.

I also remember him saying something to the effect that he had been with his current firm for over a decade and he had enough tenure to basically manage any asset class he wanted to. He then said—and I’ll never forget how confident he sounded with this comment—that high-yield bonds were the only asset class he had ever seen where, if you gave him three or more years, he was sure he could generate a mid-to-high single digit annualized return.

So look, I really don’t want to make this episode longer than it needs to be, but the point he was making is that unlike stocks, bonds are ultimately math calculations. Regardless of whether investors like the company or not, if the company doesn’t go bust, they have to pay back what they owe. On the flip side, stocks can go down for years for any reason at all, but bonds have to recover as long as they don’t default. It’s just math. So, assuming his analysis is correct and the bond doesn’t go bust, eventually the price will recover.

My follow-up to this part of the conversation was to ask how many bonds he had purchased during his career that defaulted. He proudly said, two, and he indicated he still got back around 50 cents on the dollar for both defaults. Ever since this conversation, using actively managed high-yield bond funds has been a staple of my investment strategy. In fact, my affinity towards high-yield bonds may have been the defining strategy of my entire portfolio management career.

Another quick story I remember is about a client who transferred over a large municipal bond account. He had been buying individual bonds for years with specific criteria such as credit rating, maturity, bond type, etc. Every time a bond matured, he would look to reinvest the proceeds into a new bond that fell within his parameters. After my enlightenment on high-yield bonds, I suggested to my client that he add a Vanguard High-Yield Municipal Bond fund to the mix, just so he could compare the returns. Reluctantly, he agreed.

During our meetings we would compare the return of the overall account to that of the high-yield bond fund we purchased. More often than not, the high-yield fund did better than his overall account, which clearly indicated he wasn’t adding any value by picking individual bonds himself. It took a couple years, but eventually he threw in the towel and became a firm believer in high-yield bond funds. He just needed to actually see the results with his own money to be convinced.

If you still aren’t convinced high-yield bonds are something to consider, try this stat on for size. In the calendar year after high-yield bonds have a negative return, the average calendar year return since 1987 has been over 24%. Over the same time period, the average return for the S&P 500 after a negative calendar year has been around 15%.

Let that sink in because I can’t stress my next point enough. High-yield bonds will almost always experience sharp declines at the exact same time stocks do, so they will not protect your portfolio at all during a bear market. However, if you are patient and understand the asset class, you should have all the confidence in the world they will recover, often much quicker than the stock market.

My personal experience investing in high-yield bonds backs this up all day long. In fact, I wrote an article for Kiplinger in late 2020 that outlined how I used high-yield bonds in our client accounts during the Covid-19 pandemic. Fast forward a couple years and let’s just say buying high-yield bonds during the pandemic worked out extremely well, but this article was written well before the recovery occurred. I’ve included a link in the show notes if you would like to read the Kiplinger article.

Okay, now back to the first story about the guy who had all his investments in the stock market with three years of cash. What resonated so much with me about this strategy was his comfort with stock market volatility. I have always felt the same way he did, which is why I never really liked traditional high-quality bonds as a large component of a diversified portfolio. I never understood the need to create a portfolio I knew would generate a lower return over time for the potential of minimizing losses, on paper, during financial market downturns.

However, I fully understood that three years of cash would fall short under the worst circumstances during your Drawdown Phase. So, my solution with this newfound understanding of high-yield bonds was to use a combination of stocks, high-yield bonds, and cash to create my post FI portfolio. Since I firmly believe a period of three to four years is more than enough time to see high-yield bonds recover in almost any environment, I keep a similar two to three years of cash on hand, with another five to seven years’ worth of living expenses in high-yield bonds.

This allocation should prevent me from being forced to withdraw any money from my stock investments for more than a decade, if necessary, which provides me plenty of cushion to live my FI lifestyle to the fullest. If you haven’t done so already, be sure to check out Episode 1 of Season 3 where I discuss my investment strategy in greater detail.

So, let’s put a bow on this episode by saying, in my view, high-yield bonds are a gift to investors if…if you understand how to use them. I totally realize that not everyone has the stomach to handle sharp market declines, and if that describes you, high-yield bonds should not, should not, be a part of your portfolio at all. But for those of you who understand the math, can stomach the volatility, and want to put a little time and effort into finding a top-notch high-yield bond portfolio manager, with proper risk controls and research capabilities, high-yield bonds may be right for you.

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen!” So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell. Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results.

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.