Beware of liquidity, investment risks in high-yield bonds
Investors moving into higher-yield bonds in an attempt to boost income in their portfolio should be aware of the risks, including a lack of liquidity and the risk of capital losses if the issuer fails to meet its repayment obligations, according to AMP Capital.
The fund manager’s head of credit portfolio management, Nathan Boon, said in a recent blog post that higher income did not necessarily generate positive portfolio outcomes for retirees in particular given the risks involved in such investments.
“In today’s environment of low interest rates, many investors are chasing income by moving into lower-quality high-yield bonds,” Mr Boon said.
“It’s important to understand both the risk and reward of this approach. While an overweight to high-yield credit may be an efficient way to boost a portfolio’s yield, investors need to be mindful of the additional risks they are taking on and how those risks will interact with other parts of their investment portfolio.”
Mr Boon said when it came to bonds, yield was an important indicator of the investment risks involved and may indicate an issuer was not as financially strong.
“High-yield corporate bonds have lower, speculative-grade credit ratings than their investment-grade brethren,” he said.
“The greater risk of loss implied by these lower ratings leads to higher yields because there is a higher probability that a borrower defaults or fails to meet its obligation to make full and timely payments of principal and interest.
“Historically, speculative-grade companies experience higher default rates throughout economic cycles, and particularly so during recessions, resulting in potentially significant losses to investors when these occur.”
Mr Boon added that as high-yield bonds were often not as frequently traded, there could also be difficulties for investors in selling the securities, particularly in times of market volatility.
“High-yield bond funds tend to invest in loans, corporate bonds and structured credit which are at the riskier end of the investment universe,” he said.
“When credit spreads widen, this is a reflection that the market for those securities is requiring higher compensation for the underlying risk of holding those securities — for instance, for a higher risk of default or more compensation for liquidity risk.
“In times of heightened volatility, these dynamics can become self-reinforcing; for instance, investors observing the capital value of their investment falling as risks are increasing may attempt to sell. If enough investors attempt to sell the same assets into a liquidity-constrained environment, this can exacerbate the issue, causing further loss.”