Why We Primarily Buy High Yield (Junk) Bonds Versus Investment Grade

A client recently asked about our current asset allocation and why we were purchasing high yield bonds versus purchasing a 3-month treasury bill. Of note, we have also begun purchasing some short-term treasury bills taking advantage of higher short-term yields while also positioning for additional bond purchases as the Fed raises interest rates to combat inflation. My responses below give an insight into our current strategy and portfolio positioning in light of the potential for a recession.

For the majority of our private clients (and me personally), the current allocation for our Global Income balanced strategy consists of 75% in stocks including 35% U.S. and 40% international.  It is possible that stocks continue to outpace corporate high yield bonds over the next 10, 15 and 20 years and that high yield bonds continue to outpace U.S. treasury bonds over the next 5, 10 and 20 years.  But of course, when investing there are no guarantees – even with U.S. Treasury bonds as our nation’s debt grows.

Approximately 23 ½ % of our Global Income balanced strategy is invested in fixed income with 1 ½% in cash.  Of the amount allocated to fixed income, approximately 3% (~15% of our fixed income portfolio) is invested in treasury bills with the remaining 20% invested in corporate high yield bonds.

Our corporate high yield bond portfolio currently has a yield-to-maturity of approximately 7.5% over the next 2 ½ years.

Question:  Should we purchase 3-6 month treasuries yielding 5% versus a portfolio of high yield corporate bonds with a 7.5% yield?

Answer:  Easy math would of course state that 7.5% is greater than 5% and we should purchase the corporate bonds over treasury bonds.  Of course, depending on defaults, we may not receive a 7.5% rate of return and under that scenario we may have been better off purchasing treasuries depending on the bankruptcy rate.  It is important to note that we have been paid for the additional risk of owning high yield bonds rather than safer investment grade bonds such as treasury bonds. Over the past 20 years, we have outperformed the investment grade index significantly by 1.6% per year and almost 2% per year over the past 15 years by investing in higher yielding issues.

With the current spread between high yield corporate bonds and treasury bonds being approximately 2.5% (7.5% on our current yield versus 5% for treasuries), we certainly have some cushion to provide higher returns than the riskless rate of treasuries.  That said, just as with stocks, bonds can be volatile and if we experienced more defaults than historical levels, we could achieve lower returns than 5% - or even losses in a depression type environment.

I believe that inflation will be stickier than most investors and economists and that the Fed will need to continue to raise interest rates well into next year (or at least eventually pause) in order to combat inflation.  As such, we are remaining short term in the duration of our corporate bond purchases (less than three years) as well as treasury bills preferring three-month to six-month or longer durations.  This should help to control duration risk.

Over the past 20 years, our fixed income portfolio has added significant return versus the Agg Bond index which consists primarily of investment grade bonds such as U.S. Treasuries.  The returns for our fixed income portfolio have returned 4.78% versus 3.10% for the Bloomberg US Agg Bond index adding a significant 1.68% greater return per year (more than 30% cumulatively) over the past 20 years.  That said, I cannot of course promise that we will continue to do so.

Though we’ve had a good year so far (although February and the beginning of March have seen a selloff), we could certainly experience a selloff in stocks and high yield bonds – as well as treasuries as interest rates move higher. 

As always, it is important to remain patient and disciplined when investing. No one can predict the movements of the market.  Longer term, I believe patience is rewarded when invested in higher quality companies which pay us dividends. Importantly, 80% of the companies we own raised their dividend last year even as the market sold off significantly.  This has given our clients and investors the ability to fund their retirement income needs regardless of the price fluctuations.  Over longer periods of time, stock prices have risen to hedge against taxes and inflation.  Cash and investment grade bonds cannot say the same.

Click here to view the Unconstrained Fixed Income Fact Sheet