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Investing in High-Yield Corporate Bonds? Know the Risks

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RANDY FREDERICK: Junk bonds. It’s an unflattering term for high-yield corporate debt that might be appropriate in some cases, but not necessarily in others. Collin Martin joins me for the September 25th Schwab Market Snapshot to share his expertise on when high-yield bonds might be worth a look, and when you might want to stay away.

So, Collin, I believe you have a neutral outlook on high-yield bonds at the moment. But it seems to me that there are certain sectors of the market where the risks might be quite a bit higher than others, and we got a look at this last week when a major U.S. retailer filed for Chapter 11 bankruptcy. Can you give us an overview of some of these risks?

COLLIN MARTIN: Yeah, that’s right, Randy. There are parts of the high-yield market that do have higher-risk profiles right now, but overall we have a neutral outlook on high-yield corporate bonds and they’ve performed pretty well this year. The index that we track is the Bloomberg Barclays U.S. Corporate High-Yield Bond Index. And through September 22nd it’s posted a year-to-date total return of 6.7%, so it’s doing pretty well. But there are some industries and sectors that haven’t performed as well and do have greater risks, in our opinion. One of those is retailers.

Now, over the years more and more consumers have been making internet purchases, and that’s had some negative effects on the more traditional brick-and-mortar-type retail companies. We got a prime example of that last week when retailer Toys "R" Us filed for bankruptcy protection. Now what was interesting about this situation is that Toys "R" Us has had elevated debt levels for years, and the bond credit ratings were already relatively low, but this still kind of took the market by surprise.

Now Toys "R" Us had a bond that was set to mature in October of next year, and for most of this year its price was right around its par value. Now that gives us an indication that investors in the market were generally expecting that bond to mature on its maturity date. However, when they announced the proceedings for bankruptcy protection, the price of that bond dropped below $300 relative to its $1000 par value, which represented roughly a 70% drop in value in just a few weeks.

RANDY: That’s a pretty significant decline. So given that type of volatility, would it make sense for retailers to just sort of stay completely clear of this sector, or are there certain things they might be able to do to help mitigate some of those risks?

COLLIN: We don’t think investors need to now avoid high-yield corporate bonds, but there are ways to help mitigate the risks, and one of those is just taking a more diversified approach. Whether you’re invested in individual bonds or some sort of fund, if you have diversification with a handful of issuers, that can help soften the blow if one or more of the issues does default.

Now if you’re investing in individual high-yield bonds it’s best to really understand what it is you’re buying, but also understand the risks you’re taking for the yields offer. For example, if you see a bond with a relatively high yield, compared to other bonds with similar credit ratings or similar maturities, there’s a good chance that there could be some unique risks to that specific bond that could pull the price lower given certain circumstances.

And then last, we think an important thing to do is to focus on active management or a more professionally-managed approach. Now it’s really difficult for individual investors to stay abreast of everything that’s going on in the market, whether that’s the broad high-yield market or individual issues. Now an active approach or a professional manager really has the time to do that since it’s their job to be managing those risks relative to the yields offer. Now if you are interested in high-yield corporate bonds, we think it’s best to speak with a Schwab Fixed Income specialist who can help go over the various options and find out what the best approach is.

RANDY: Thanks, Collin, that’s great information, and I think talking to a Schwab expert is really good advice. Listen, if you want to read more from Collin you can do that in the Fixed Income section of Schwab.com. And don’t forget, you can follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely, own your tomorrow.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions.

Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Investing involves risk including loss of principal.

Definitions

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

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