Is It Safe to Invest In High Yield Corporate Market?

By Larry Swedroe, on April 5, 2009

Question

Is it safe to enter into the high yield corporate market yet, seeing that ETFs such as HYG and JNK are still near their 52-week lows, but heading higher. One would think that as the stock market rebounds, these funds should also. But, I am concerned that if the market took a down turn (i.e., if we are in a bear market rally), whereas normally these funds should react inversely to the market, they could once again synchronize with the equity markets and lose some of their value.

Thanks,

Randy

Answer From Larry Swedroe

Great question. What most people don’t understand is that high yield bonds are really not bonds, but are what would are more appropriately called hybrids. Depending on the credit rating the percentage that is really equities will vary. For example, the Vanguard high yield fund is really about 22% equities and a CCC fund would be like 50%. So if you buy such a fund you need to adjust your asset allocation to reflect the fact you are taking a lot more equity risk.

Another problem is one of location. You should prefer to hold equity risk in taxable accounts and bond risk in tax advantaged accounts and with a hybrid (be it junk, preferred, convertibles or even EM bonds) you are holding one of the risks in the wrong location, assuming you have a choice of location. Moreover, you can get the Treasury exposure (the bond portion) without paying the high expenses of a mutual fund.

Bottom line is that while I agree that expected returns are now high (because the risks are now high), you are significantly better off simply increasing your exposure to small and value stocks instead — and stick with Treasury Inflation-Protected Securities (TIPS) for your bonds in tax advantaged accounts. That is a much more efficient way of taking risk. You can read more about why I don’t recommend any hybrids in The Only Guide to Alternative Investments You’ll Ever Need.

I hope the above is helpful.

Best wishes,

Larry

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Leave Your Comment (2 Comments)

1. eqwitty says:

   April 11, 2009 at 3:02 am

   Larry, you say that the Vanguard High Yield Fund is really 22% equities. Are you stating that percentage in relation to its average bond rating and assigning it an “equity-like” risk profile to the rating or are you looking at specific holdings?

   Reply
2. Larry Swedroe says:

   April 11, 2009 at 10:51 pm

   That was the finding of a stuy based on the history of the fund. Obviously will change over time–the lower the credit rating the more equity like it will be

   Reply