Some investors have gravitated toward High-yield corporate bond ETFs in an effort to generate additional income. There is nothing wrong with investing a component of your portfolio in such an investment on the condition you are fully aware of the risk exposure you are taking on and can withstand a permanent impairment to your capital if companies start to default on these higher risk instruments.
I am personally aware of a retiree who shifted a component of his relatively ‘safe’ portfolio to a High-yield corporate bond ETF a few years ago. The reasoning for this is that GICs with reasonably attractive interest rates were maturing and GICs of similar duration and credit risk were not providing the revenue stream this retiree required to meet his ongoing living expenses.
In an effort to generate the required income without seriously encroaching on his capital for fear of running out of money before his ‘time was up’, this retiree invested some of his retirement money in a High-yield corporate bond ETF.
The situation reflected above is not uncommon. Investors often add a bond component to their investment portfolio for the purpose of providing income and stability. The issue, however, is that not all bonds are the same. Depending on such factors as bond type, maturity, and quality, bonds can behave very differently. As a result, it is extremely important to be fully aware of what types of bonds are being added to a portfolio otherwise less than desirable results could be achieved.
Yield and bond default risk are positively correlated. The reason for this is that investors require additional compensation in exchange for an increase in the risk of capital losses.
High-yield bonds are issued by corporations that are less likely to meet their financial obligations to creditors. As a result, credit rating agencies assign ratings defined as ‘Non-investment grade speculative’, ‘Highly Speculative’, or ‘Substantial Risks’.
When bonds of inferior quality are held in an ETF, investors must be cognizant that there is a definite possibility a portion of their investment will be lost if an issuer defaults. Herein lies the problem….the market often underestimates the probability of a negative outcome.
If we go back to 2015 and 2016, many companies with high financial risk which were heavily exposed to the energy and commodity spaces suffered ratings downgrades. In 2015, for example, Moody’s reported default rates of 6.3% in the oil and gas sector and 6.5% in the metals and mining sector which drove the overall junk bond default rate to 4%. Matters deteriorated further in 2016 when a 13% default rate was reported in Q2 2016 in the energy high-yield bond category; this exceeded the previous high set in 1999.
The following table reflects the ratings assigned by the Moody’s, S&P Global, and Fitch rating agencies together with a description of the ratings.
I provide links to 4 High-yield bond ETF product offerings. When you look at these offerings you may wish to refer to the Credit Rating Chart.
If you look at the first BlackRock offering, for example, you will note that this ETF has:
- over 84% of the ETF invested in non-investment grade speculative and highly speculative rated holdings;
- holdings with coupons in excess of 9%.
Many of these heavily indebted companies have bonds which mature in the next few years. This presents a challenge from the perspective that we:
- are now in a rising interest rate environment;
- have experienced strong market conditions for the past 8 years;
- an economic correction is not out of the realm of possibility within the next 1 – 3 years.
If history is any indication of what we can expect in the future, I strongly suspect that in the next economic downturn we will see a pick-up in default rates on these higher risk securities. As a result, it is imperative you be fully aware that default on some of these bonds is not totally out of the realm of possibility.
High-yield bonds are an altogether separate species from investment-grade bonds. I do not deny that high-yield bonds may be a suitable component of an investor’s diversified portfolio but unless you are:
- truly aware of the risks these offerings pose;
- willing to accept a permanent impairment to your capital if some of these issuers start to default on their obligations
you would be well advised to steer clear of High-yield bond ETFs.
Unfortunately, I strongly suspect many investors holding High-yield bond ETFs in their portfolio do not truly understanding there is a very strong risk of a permanent impairment to their capital. Hopefully you were not in this predicament before reading this article. If you were, hopefully this article will prompt you to re-evaluate whether your current level of exposure to High-yield bond ETFs is appropriate in your circumstances.
In the case of the individual to whom I referred at the beginning of this post, he has not yet suffered any permanent impairment to his capital. He has, however, re-assessed his exposure and has decided to scale back on some of his living expenses and to slightly reduce his exposure to a High-yield bond ETF.
I wish you much success on your journey to financial freedom.
Thanks for reading!
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Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.