High-yield Bonds: Overvalued, But Still Worth a Look?

High-yield bonds, also known as junk bonds, may seem like a risky investment, especially when experts say they're overvalued. However, there are reasons why these bonds might still be worth considering for your portfolio.

• Yield Advantage: Despite being potentially overvalued, high-yield bonds offer a significantly higher yield compared to safer alternatives. The SPDR Bloomberg High Yield Bond ETF (JNK) yields 6.94%, considerably more than the iShares Core U.S. Aggregate Bond ETF (AGG) at 4.6%. In a low-interest-rate environment, this extra yield can be attractive.
• Outperformance: High-yield bonds have delivered excellent results in recent years. The SDPR ETF returned 13.2% in 2023 and 7.4% in 2024.
• Less Sensitive to Interest Rate Hikes: High-yield bonds are less vulnerable to rising interest rates compared to investment-grade bonds. They have nearly half the duration risk of core bonds.
• Higher Quality: The quality of high-yield bonds has generally improved. Double-B bonds, a higher tier within the below-investment-grade category, now constitute a larger portion of the market (54% versus 38% in the early 2000s).
• Limited Impact from Tariffs: High-yield-issuing companies primarily focus their sales in the U.S., which means that tariffs will have a much more limited impact on them.
• Inflation Hedge: For highly indebted companies, inflation can be helpful, as debts become easier to repay as prices rise.

 

Risks to Consider

• Overvaluation: Veteran analyst Marty Fridson views high yield as "severely overvalued".
• Credit Risk: There is always the risk that the companies issuing these bonds may default on their payments.

 

How to Approach High-Yield Bonds

• Active Management: Consider actively managed high-yield funds. These funds can potentially outperform passive index funds by carefully selecting bonds and managing risk. Michael Arone, chief investment strategist of State Street’s SPDR ETF business, is a fan of the SPDR Blackstone High Income ETF (HYBL), which yields 6.9% and incorporates leveraged loans and collateralized mortgage obligations in addition to high yield.
• Focus on Higher-Rated Junk Bonds: Experts recommend sticking to the higher-rated portions of the junk bond market to mitigate risk.
• Consider individual circumstances: Investing involves risks, including loss of principal and may not be suitable for all investors.

High-yield bonds can be a valuable addition to a diversified portfolio, offering attractive yields and potential downside protection. However, it's crucial to acknowledge the risks and approach this asset class with caution, focusing on quality and active management.