Junk is Hot

The Wall Street Journal reported yesterday that the yield on high yield bonds fell below 7% for the first time in more than six years. Investors, fed up with low yields in bank products and bonds, have thrown caution to the wind and added riskier debt to their portfolios.

As a quick refresher, when investors bid up the prices of fixed income securities (e.g. bonds), the yield goes down. A 7% yield is what we would expect from investment grade debt in a more normal interest rate environment. However, the current environment is far from normal.

I find this interesting, because I am responding in a rather different way. I have begun moving all clients out of intermediate term debt. We were never in long term debt, as the risk-return characteristics are unappealing. I am now moving out of intermediate term debt. I am also shifting and even greater percentage of the fixed income portion of client portfolios to higher grade debt. While I rue the low yields in short term, high grade bonds, I am not willing to take the risks associate with longer maturities and lower credit risk.

The Journal reports that high yield or "junk" bonds are up 2.57% this already. They were up 15.2% in 2010 and 57.5% in 2009. The risk premium - the extra yield investors demand to own riskier investments - has fallen to 4.68% over the Treasury yield. The historic risk premium is about 5% above Treasuries.

My self-directed research suggests investors are not adequately compensated for taking the risk associated with junk bonds. Therefore, I do not include them in client portfolios.