Financial products
Junk bonds attract investors: what risks?
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Morningstar Direct calculated that US funds investing in high-yield bonds received an impressive $6.8 billion in July. This is a remarkable figure, which can provide an opportunity to highlight both the opportunities and risks associated with these financial products. Certified Financial Planner (CFP) Kate Dore of 'CNBC' also wrote about it.
High-yield bonds - also referred to as 'junk bonds' - are financial products characterised by returns and risks that are on average higher than those of many other financial assets. For this reason they are also called 'junk bonds'. The high yields they offer are to a large extent linked to their default risk. As many central banks have raised interest rates, the bond market has seen yields rise on average. Junk bonds have been no exception. This is well illustrated by the ICE Bank of America U.S. High-Yield index (whose data is also quoted in Dore's article), which rose from 4.42% at the beginning of the year to almost 7.3% on 10 August.
Bond yields rise as interest rates rise for a simple reason: it always costs more to refinance debt. The reason why many investors are betting on junk bonds can be found in two factors. 1) On the one hand, the attractive interest rates. 2) On the other, the high inflation rate (in the US 8.5%), which is difficult to overcome with more traditional and safe financial products. As Charles Sachs, chief investment officer of Kaufman Rossin Wealth, says, investors should not opt for junk bonds as their prevailing investment: according to the expert, an allocation in these risky investments of 3% to 5% could be more than sufficient.
As Kate Dore explains in her article, the attractiveness of junk bonds also lies in the spread with safer products, such as US Treasury bonds. When the spread approaches and exceeds a certain threshold, investors are more likely to invest. In the US, for example, on 10 August the spread between the yield on high-yield bonds as measured by the ICE Bank of America index and 7-year Treasuries was 4.43%. In terms of actual return on a $1,000 investment - the calculation is always by Dore - we are talking about $28.60 earned in one year by investing in 7-year Treasuries and $72.90 in a fund that replicates the ICE Bank of America U.S. High-Yield index. In reality, as Matthew Gelfand, CFP and executive director of Tricolor Capital Advisors, points out, the current spread is not far from (in fact, it is slightly less than) that measured over the past 40 years, which is 4.8%.
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