The Hidden Dangers of High-Yielding Bonds
If you’ve been following these videos for any length of time, you’re probably aware that I don’t much care for “rules of thumb” regarding investing or financial planning. Generic advice is almost never better than individualized planning, because every unique situation requires a unique strategy.
But – if I had to pick a rule that’s as close to iron-clad as you’re likely to find, it is this: risk and reward almost always tend to go hand in hand. You can’t expect to get higher returns without accepting higher risk, nor can you expect lower risk without also accepting a lower rate of return.
Up until early 2022, interest rates had been at near zero for more than a decade which tempted some people to look for investments that were offering better yields than what money markets and CDs were paying – a phenomenon known as “chasing yield.” And while interest rates have come up over the past several months, the volatility of the stock market has caused some people to continue to chase yield, in spite of the inherent risks in doing so.
Incremental Maturity Risk
In the bond world, higher yields can be potentially achieved in two ways. The first is by taking incremental maturity risk – buying longer maturity bonds – which leaves you vulnerable to rising interest rates as inflation heats up, thus increasing the volatility of your portfolio in a big way. We’ve seen this happen already. Don’t forget, when interest rates rise, the value of your bonds goes down. And the longer it is until that bond matures, the more volatile its current value can be.
The second method of chasing bond yield is to take credit risk, where you could lose money if the bond issuer fails to make timely payments of interest and ultimately principal. So if, for example, you’re investing in corporate junk debt, you may be looking at a yield that much higher than what you’re going to see with more stable companies. This is because an investor is going to demand a higher current return than investors who own investment-grade corporate debt.
Stocks and Bonds
Bonds are often added to a portfolio to act as a kind of hedge against the risk of owning stocks, because during stock market downturns, ideally, you want your bond investments to act as a safety net and help cushion the impact of losses in your stock portfolio.
But what have we seen in 2022? Falling stock prices AND falling bond prices as interest rates have risen, meaning that many people did not get any offset during this volatile market. And of course if you own lower-quality, high-risk “junk” bonds or longer maturity bonds in an attempt to prop up your rate of return, the negative effects have been magnified.
There’s no shortage of headlines and websites telling you where to find high-yielding investment opportunities. But before you jump in, keep in mind that chasing yield doesn’t always end well. Whether it’s stocks or bonds, once a point of inflection happens, it’s then just a matter of who’s left holding the bag.
This is why we have a strategy. If you want to learn more about how a Bucket Strategy aims to solve problems like these, contact us. As always, we’re here to help!
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