With interest rates at zero, it’s a great time to be a borrower but a lousy time to be a saver. While fixed-rate mortgages have hit record lows, so have rates on interest-bearing products like high-yield savings accounts, CDs, and money market accounts. But should you alter your bond portfolio in search of higher yields? Let’s take a look.
One way investors can try to reach for yield in their bond portfolio is by investing in high yield bonds. The investment objective is right in the name, high yield. But you should also know that these bonds are nicknamed “junk bonds” not because they are worthless but because they are issued by companies with credit ratings below investment grade and thus have a higher chance of defaulting on their obligation to pay bondholders back.
Think of someone with a low credit score trying to take out a bank loan. The bank can see all the past-due bills and collection agency remarks on that person’s credit report but decides to go ahead and give them a loan anyway but at a higher interest rate, since it’s possible that this person may default on their promise to pay the money back at some point in the future. The same idea applies to junk bonds, they can provide additional yield but as an investor you must accept the risk that the company may default on its obligation, and when that happens the bond’s value can fall.
Historically bonds and stocks are uncorrelated asset classes, meaning when one asset class rises the other falls. Having uncorrelated assets in a portfolio helps with diversification, so that when one part of portfolio does poorly the other does better.
Correlation is a statistical measure represented by a number between -1 and +1. A correlation of 0 means the price movement of one asset has no effect on the price movement of another asset. A correlation of -1 means that prices move in opposite directions and a +1 is a perfect positive correlation, meaning prices move in the same direction.
The chart below from JP Morgan’s Guide to the Markets shows just how correlated domestic high yield bonds (US HY) are to the stock market. You can see here that high yield bonds have a correlation of about 0.8, meaning prices move in tandem with the stock market.
Another way investors can attempt to seek yield from their bond portfolio is by purchasing bonds with longer maturities. When we have a positive yield curve, like we do now, bonds with longer maturities pay more than bonds with shorter maturities. If you think about it, this makes sense because when buying a 30-year bond you’d expect to be paid more on your investment since your money is tied up for a longer period of time. But these longer maturity bonds come with higher interest rate risk, meaning that a potential uptick in rates could significantly reduce the bond’s value.
Interest rates and bond prices have an inverse relationship so when interest rates rise the price of a bond can fall, and vice versa. The longer the term on the bond the greater it’s fall when rates rise. Say an investor has a 30-year bond with a 5% coupon. When interest rates rise to 6% that investor is going to have a harder time selling that bond out in the market since there are now new bond issues with higher, more attractive yields. The lower demand in the market for the 5% bond means lower selling price.
There are a lot of ways to structure a bond portfolio, and quite frankly there aren’t as many levers to pull as there are when constructing the equity side of a portfolio. But before you take undue risk, you have to consider why you have a bond portfolio in the first place. If it’s to have stock-like returns, why not just invest in stocks to begin with?
If your goal is to have a hedge against the volatility in your stock portfolio or to preserve capital, you might want to re-think the types of bonds you’re investing in and eliminate risks where they may not be necessary. By going out further on the yield curve or by investing in lower credit quality bonds you could be creating risk in places where you should be creating security. Staying relatively short-term on the duration and increasing the credit quality of your bonds can decrease some of these risks and create stability where you need it most.