Why You Should Think Twice about High Yield Bonds | Common Sense Investing | Summary and Q&A

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December 1, 2017
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Ben Felix
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Why You Should Think Twice about High Yield Bonds | Common Sense Investing

TL;DR

High yield bonds, although offering higher potential returns, come with increased risk and volatility, and may not add value to a portfolio.

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Key Insights

  • ✋ High yield bonds, often considered alternative investments, offer higher potential returns but come with increased risk and volatility.
  • ✋ Research has shown that the risk and returns of high yield bonds are similar to stocks, making them unsuitable for stability in a portfolio.
  • ✋ Portfolios with high yield bonds have higher volatility without significantly higher returns, resulting in no added value on a risk-adjusted basis.
  • ✋ Experts like Larry Swedroe and David Swensen caution against investing in high yield bonds, stating that investors have not realized greater risk-adjusted returns with this security.
  • ✋ High yield bonds are tax-inefficient due to their high taxable income and equity-like behavior.
  • ✋ Diversification and using low-cost high-yield bond ETFs are recommended for those including high yield bonds in their portfolio.
  • 😘 Individual high yield bonds should be avoided due to the risk of default and low recovery rates.

Transcript

At a certain point, good old stocks and bonds might start to seem a little bit boring. There has to be more out there, especially when you start to build up substantial wealth. These other types of investments are often referred to as alternatives. They sound much more exciting and exclusive than stocks and bonds, and are typically sold as having h... Read More

Questions & Answers

Q: What are high yield bonds and how do they differ from other bonds?

High yield bonds are riskier bonds with lower credit ratings and higher yields compared to safer bonds. They offer the potential for higher returns but also come with increased risk of default.

Q: Are high yield bonds suitable for stability in a portfolio?

High yield bonds are considered too risky to serve the purpose of stability in a portfolio. They have been found to have similar risk characteristics to stocks, and the expected returns are mostly explained by equity returns.

Q: Do high yield bonds add value to a portfolio?

Although high yield bonds have shown high average returns in isolation, studies suggest that including them in portfolios does not add value on a risk-adjusted basis. Portfolios with high yield bonds have higher volatility without significantly higher returns.

Q: Are high yield bonds tax-efficient?

No, high yield bonds are tax-inefficient as they pay relatively high coupons that are fully taxable as income. Considering their equity-like behavior, they are not an efficient way to gain equity exposure.

Summary & Key Takeaways

  • High yield bonds are riskier bonds with lower credit ratings but offer higher yields.

  • Research suggests that the risk and returns of high yield bonds are similar to stocks, making them less suitable for stability in a portfolio.

  • Portfolios with high yield bonds have shown slightly higher returns but significantly higher volatility, resulting in no added value on a risk-adjusted basis.

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