Manage risk of junk bond market by diversifying

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In this era of low interest rates, high-yield bonds offer investors a seductive promise – generous payouts with no stock market risk attached.

But investors who buy into this asset class may not realize the risks that come with it – risks so high that many investors may decide to shy away from the area, or restrict their investment to only a tiny slice of their portfolio.

High-yield bonds are also known as junk bonds or below-investment-grade bonds. They're bonds that are too risky to get the top investment-grade ratings from credit raters such as Standard & Poor's, Moody's or DBRS.

Their lofty yields are a byproduct of their built-in risk. Around the world, about 4.8 per cent of high yield bonds have defaulted since 1983, according to Moody's.

In good times (when default rates are low), or in an improving economy (when default rates are decreasing), high-yield bonds can produce strong results. However, when the economy takes a turn for the worse and default rates spike, they can leave your portfolio smarting.

High-yield bonds were rare in Canada until about three years ago. They began to make strides when new tax laws cracked down on the income trusts that had previously been the favourite fare of income investors. People looking for regular cash injections slowly began turning to high-yield bonds, taking advantage of their handsome returns.

The high-yield market in this country is still small. In September, Moody's bond-rating service estimated that about $9-billion in high-yield bonds had been issued in Canada since 2010, versus $3.3-trillion in the U.S.

However, the perception of high-yield bonds has improved more than the raw numbers might suggest, said Hanif Mamdani, head of corporate bond investments at RBC Global Asset Management, which operates the Phillips, Hager & North High-Yield Bond Fund.

High-yield bonds, he said, have "transformed from an asset class that was considered obscure, speculative and risky to something very mainstream right now."

Still, he's quick to add that high-yield bonds have a "notoriously cyclical" nature and suggests that investors adjust their exposure depending upon their outlook for the economy and interest rates.

Timing is also a key issue for Francis Pelletier, who co-manages the Altamira Management Ltd. High-Yield Bond Fund for Fiera Capital Corp. He says that high-yield bonds are a smart choice for investors looking for returns in the current economic environment.

"Equities are not going to be delivering exceptional returns" over the next few years, Mr. Pelletier said. "At the same time, there's a low nominal growth environment with the [economic] stability conducive for low [bond] defaults."

Bonds are typically hurt when interest rates rise, but Paul Tepsich, who manages Scotia Capital Inc.'s Advantaged Canadian High Yield Bond Fund through his company High Rock Capital Management Inc., says he isn't worried about the potential threat from higher rates down the road.

"If that happens, it will be because the economy is finally improving," he said. An improving economy would mean companies' cash flow is increasing, reducing the risk of default.

High-yield bonds may appeal to retired investors looking to squeeze maximum income out of their portfolio. But given the default risk, it's too dangerous to hold only a single bond; better to invest through a fund that holds a well-diversified blend of such securities.

Even then, the risks are too high for the average investor, said Eric Kirzner, finance professor at the Rotman School of Management in Toronto. "There's the risk that default rates start to increase, or the fund manager does a poor job assessing risk, or the market decides it doesn't like these products," he said.

"If people are chasing yield, you don't want to do it through a high-risk approach," Mr. Kirzner said. He recommends investing no more than 5 per cent of a portfolio in high-yield bonds, and says investors should make sure that any high-yield fund they invest in is well diversified.