Give Your Portfolio a Boost With High-Yield Bonds

by Anthony Summers, Senior Research Analyst, The Oxford Club

What’s your asset of choice?

For most investors, the answer is stocks. Which comes as no surprise. Investing in the stock market has historically proven the best way to grow your wealth.

Over the long term, stocks outperform all other asset classes. But smart investors put their eggs in many baskets. And in the current market environment, it’s important to know your alternatives.

One of those alternatives is high-yield corporate bonds. It’s the focus of this week’s chart.

First, a brief summary of corporate bonds...

When an investor buys a corporate bond, they are lending money to a company at a set interest rate. Interest payments are paid regularly to the investor until the bond reaches its maturity date. At this point, the company pays back the entire value of the bonds purchased.

The bond market is broken into two broad categories based on a company’s ability to pay back its loans: investment-grade bonds and high-yield bonds.

Investment-grade bonds have the highest credit ratings. That means the companies that issue them are best equipped to pay them back.

High-yield bonds - also known as junk bonds - have lower credit ratings than their investment-grade peers. This means there’s a higher probability that a company could default on its loans.

But don’t let the name fool you. “Junk” bonds still have a place in an investor's portfolio. (In fact, Chief Investment Strategist Alexander Green recommends allocating 10% of your portfolio to high-yield bonds. You can read more about that here.)

As you can see in the above chart, high-yield bonds are currently offering an average yield to maturity (YTM) of 9.9% in annualized returns. YTM is calculated by taking the total amount of interest payments plus the spread between the par value and the purchase price.

How are investment-grade bonds holding up? At the moment, they bestow a mere 3.5%.

That’s a huge difference on its own. But there’s one type of high-yield corporate bond that offers an even bigger YTM...

Energy.

With the price of crude oil at 12-year lows, oil and gas companies are experiencing reduced sales and earnings. Many energy investors have been panic-selling both stocks and bonds.

But lower bond prices also means higher yields. By purchasing bonds at below their par value (typically $1,000), you can actually receive a higher yield than the stated interest rate.

For example, a bond with an interest (or coupon) rate of 5% will pay out $50 per year. If you were to buy this bond from a panic seller for $800, your yield would actually be 6.25% ($50 is 6.25% of $800).

On top of that, you would receive the entire par value of the bond ($1,000) on the maturity date, which is an extra $200 over the $800 you paid.

The table above ranks each sector by the average YTM for high yield bonds. As you can see, the energy sector stands far above its peers.

The average YTM for energy sector high-yield bonds is a whopping 17.8%. Compare that to the industrials sector with the second-highest average YTM of 11.4%. Meanwhile, the materials sector stands in third place at 10.7%.

Of course, putting too many of your eggs in the high-yield basket can be a setup for failure. As our Bond Strategist Steve McDonald always says, “Don’t be a rate pig.”

Yet even with the added risk, this asset class definitely deserves a second look.

Just remember to do your due diligence before investing in these riskier investments.

P.S. In his more than 20-year career as a bond trader, Steve McDonald has seen it all. But just recently, he spotted a trend that’s eerily similar to one he noticed back in 2000... just before the dot-com bubble burst. Fortunately, he’s figured out a way for investors to sidestep disaster - and pocket as much as $56,744 in cold hard cash. Click here to find out how.

Chart of the Week