Seeking Alpha: What makes high yield bonds appealing for income investors now?
Salo Aizenberg: I view high yield bonds as an alternative to the more volatile stock market, which many investors remain wary of, and the ultra-low yields available on treasury bonds and most classes of investment grade bonds. Ten-year Treasury yields are at their lows for the last two years and at the same time, the stock market is stuck in a holding pattern, basically flat for the last 20 months with seemingly little to propel it forward. With this in mind, the yields on high yield bonds are particularly appealing today and can offer an investor with a multi-year investment horizon a way to lock in a reasonable return with less risk than stocks.
SA: It seems using the term "junk bonds" to describe high yield bonds is something of a misnomer these days. However, many investors still avoid them -- even the professionals. What's your take, and why would you advise investors to ignore this long-held moniker?
Salo: I view high yield bonds, also known as "junk bonds," as one of the least understood asset classes among investors, including professionals. Many asset allocation models do not specifically include high yield bonds, or add in a small percentage as some "alternative" investment to include with great caution. The word "junk" seems to scare away investors -- even though this asset class is far less risky than stocks, but no one would call stocks a "junk" investment. I consistently remind investors I work with that over the last 25 years, returns on high yield are close to stock market returns, but with 40% less risk.
Over the last 10 years in particular, high yield returns have outpaced stock market returns by 3% per annum, again with 40% less risk. With these results in mind how can allocation models ignore the asset class? In the last two market crashes (2000-2002, 2008), high yield bonds performed far better than stocks, another important marker for investors seeking to reduce risk. The word "junk" goes back to the 1980s and the days of Drexel Burnham and the birth of the high yield bond market -- at that time, the moniker was warranted. Today, high yield bonds are simply corporate bonds from issuers that the rating agencies have decided are not at least BBB-/Baa3. There is no magic that suddenly makes a BB rated bond "junk."
SA: What is your view of high yield bond funds? In your opinion, what is the best way to invest in them?
Salo: Investors need to understand that a high yield bond, like any corporate bond, is simply a contractual obligation between a company and the bondholder to pay the investor interest every six months (typically) and principal back on the maturity date. Each bond is thus its own investment unit and can be evaluated and purchased on its own merits, not as part of some larger "asset class" that is in favor or out of favor at the moment. Bonds can be decoupled from being part of a monolithic asset class. The only analysis necessary to evaluate a bond is deciding if you think the issuer will go bankrupt -- forget P/E ratios and technical charts -- can the issuer pay its interest and principal, and is the risk of bankruptcy negligible? My strategy is to evaluate each bond on its own merits, ignoring the movements of high yield as an asset class, and create a diversified portfolio of bonds that I am happy to hold through the maturity date. In this way an investor can ignore the ups and down of the market. Bond funds do offer good diversity and are certainly appropriate for smaller investment amounts, but also expose investors to market segments they may want to avoid -- like the lowest rated CCC bonds and risky energy names. An index fund by definition has exposure to all these segments.
SA: Some economists are forecasting that a potential recession may be on its way. Is the high yield market giving any indication about this either way, and do you agree that we might, indeed, be headed for recession?
Salo: I make it a point to never make predictions about the direction of the market or the economy. That being said, eventually there will be a recession; it is inevitable. I don't think the high yield market is a good litmus test of where the economy is going. It seems to respond to many other factors from stock market movements to oil prices. To defend against a recession, it goes back to my earlier comment -- perform the credit analysis and pick high yield issuers that can survive a recession. One thing I look at is how the company managed in 2008-2009 -- this is a pretty good data point for how a company performs in an economic downturn.
SA: Your bio mentions you provide investment advisory services to retirement plans, which I know has more to do with investment policy statements and fiduciary issues and the like. As an extension of that expertise, how would you suggest retirees position themselves in light of the current economic environment? Where do bonds fit into such a strategy?
Salo: My service to 401(k)/403(b) plans focuses on providing plan sponsors a lineup of mutual funds that is focused on a diversified selection of the lowest cost index funds. I partner with Charles Schwab to deliver turnkey retirement plans -- my firm provides the investment advice and mutual fund lineup. Most incumbent plan providers receive fees from the mutual fund companies for selecting their fund for a retirement plan. While disclosed, this is a shocking conflict of interest, which is getting more scrutiny by the regulators. Since I don't get paid by the mutual fund companies, I select the best and lowest cost mutual funds available. One plan I completed, with about $3 million in total plan assets, reduced the all-in cost from 1.2% per annum to 0.68% per annum.
For retirees and current investment allocations, there is never one answer. It depends on various factors from risk tolerance to income needs, and I would suggest that retirees create an allocation plan. But I would say high yield bonds offers an excellent way to avoid on one side the often gut wrenching volatility of the stock market, and on the other side the impossibly low yields of CDs and other bonds. We have several retired clients who have moved completely away from both these asset classes and are enjoying the steady income stream from a diversified portfolio of high yield bonds that they intend to hold to maturity.
SA: Is there anything else you'd like to share with readers?
Salo: My main message about high yield bonds is that they should be included in everyone's asset allocation plan, which for most investors certainly should include stocks and other types of bonds. But it is not an asset suited for trading; holding the individual bond is the best way to invest in high yield as an investor benefits from the certain maturity date and fixed interest payment to lock in a return.