How to Invest in High-Yield Bonds

I’m 10 years old and sitting at the kitchen table with my grandfather. I remember it like it was yesterday. He was reading the paper and I kept asking him questions about the stock market. I must have been on my 3,000th question when he told me something shocking. At least to my 10 year old brain…

You could loan money to people, and they’d give you more money back.

It was a very simple concept, learning about interest. But I was blown away at the time. My mind raced with thoughts of making lots of money. That’s how my first introduction to bond investing went. Loan out money, get more money back.

Over the years I’ve learned a great deal about investing from my grandfather. He’s explained stocks, bonds, commodities, even real estate. I remember the discussion about bonds most clearly.

Right now many high-yield bond investors are feeling the same way I felt then… excited and happy!

Last week, High Yield Corporate Bond funds received the largest inflow of cash in many years – $ 882 million in all. This is on top of the $ 690 million and $ 731 million invested during the last two weeks of December.

That’s a lot of money being put to work.

Why are investor dollars flowing into these funds at such a high rate?

Before we get to that… let me tell you a little bit about high yield bonds.

High yield bonds are bonds with a great PR (public relations) firm. You may know these bonds by their less flattering name – Junk Bonds.

High yield or junk bonds are typically issued by companies with a credit rating below “BB.” Their stated interest rates are usually three or four percentage points higher than those of government bonds.

Why the higher rate?

Because they have a higher risk of default.

Most high yield bonds are issued for one of two reasons – general corporate purposes or to fund an acquisition. In the 1980s the junk bond industry became famous for financing the leveraged buyout boom. Today the high yield industry has issued more than $ 600 billion in bonds and has offerings from nearly every industry.

So what’s so special about these bonds? Why is all this money flowing into high yield bond funds now?

I’ve got one word for you – YIELD.

Right now a 10-year U.S. Treasury Note (T-Note) is yielding about 2.3%.

High yield bonds normally provide 4 or 5 percentage points of yield over T-Notes. That’s known as the spread. Today the Merrill Lynch High Yield 100 has a yield of more than 12%, a spread of more than 10 percentage points over T-Notes.

That’s more than double the normal spread.

But that’s nothing. Earlier this year the yield was over 17% – that’s a spread of almost 15%.

The spread’s a great indicator of fear. The bigger the spread, the bigger the fear companies will be going bankrupt. Clearly the market was very, very fearful when yields were 17%. Now yields are falling and the spread is tightening… a good sign the markets are returning to normal.

The opportunity to grab part of these big yields is quickly slipping away. As investors on the sideline become disgruntled with government bonds only paying 2%, it won’t be long before they’re looking for something with a better return.

Now there is a risk. Some of these companies could go bankrupt rendering their bonds worthless. Investors might lose a chunk of their hard earned money… to some that’s a risk worth taking.

If you want to buy into these funds you might look at a high yield bond mutual fund. According to Morningstar there are more than 150 to choose from. I know Vanguard has the High-Yield Corporate Fund (VWEHX), or you might look at the Fidelity Capital & Income Fund (FAGIX).

There’s an ETF you can trade as well.

One I like is the iShares iBoxx High Yield Corporate Bond (HYG). It boasts heavy trading volume and a 12% yield. With assets just under $ 1 billion, they’re not as big as the mutual funds, but big enough to provide some decent diversification.

Take a close look if you want to add a high yielder to your portfolio.