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If you’re worried about rising interest rates, you may be eyeing high-yield bonds, which typically pay a bigger coupon and may help offset price declines in your bond portfolio. But these assets may also carry more risk, according to financial experts.
While market interest rates and bond prices typically move in opposite directions, high-yield bonds generally have a big enough coupon to cushion some of that principal loss, said certified financial planner Howard Pressman, partner at Egan, Berger & Weiner in Vienna, Virginia.
“That’s definitely an attractive feature in a higher-rate environment,” he said. But the trade-off of the bigger coupon is that high-yield bonds may be riskier than their investment-grade counterparts.
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Bonds have a credit rating system, gauging an issuer’s ability to cover interest payments and loans by the maturity date.
While investment-grade bonds are considered safer, these assets may pay smaller coupons. And high-yield bonds, also known as junk bonds, may have greater default risk but typically provide a bigger yield.
According to Pressman, advisors often compare the “spread” between bonds’ coupon rates when deciding whether to purchase high-yield bonds.
There’s no absolute number, but as the spread widens, high-yield bonds may become more attractive, whereas closer coupon rates mean there’s less of a reward for taking on more risk, he said.
Moreover, high-yield bonds may act like stocks, performing well when the economy is strong, Pressman said, but prices can fall dramatically in a downturn.
“The yields on these things are just not very high anymore,” said Brian Moriarty, associate director of fixed-income strategies at Morningstar, explaining the payouts may be less attractive than a year ago. “You’re talking 3% or 4%, maybe less in some cases.”
However, crafting a bond portfolio is a compromise, as you’re often trading one type of risk, depending on the chosen funds.
“Do you want more [interest] rate risk or credit risk?” Moriarty asked. “Because you really can’t have your cake and eat it, too, in the bond world.”
Still, high-yield bonds may be a “good diversifier” for the fixed-income part of a portfolio, which is designed to preserve capital and provide income, said Jon Ulin, a CFP and managing principal of Ulin & Co. Wealth Management in Boca Raton, Florida.
“A lot of clients of all ages don’t understand bond diversification and the different flavors of credit quality and interest rate risk,” he said.
Ulin uses a “barbell” approach, split between short-term and long-term bonds, with investment-grade and high-yield assets.
You also need to be mindful of so-called duration, which measures the bond’s sensitivity to interest rate changes, based on the coupon, time to maturity and yield paid through the term. Typically, the longer a bond’s duration, the more likely it may be affected by future rate hikes.