“Income Factory” author Steven Bavaria explains how so-called “junk” securities are often less risky than many of the stocks investors already hold in their portfolios.
High yields have gotten a bad rap among many investors and financial writers over the years. Pejorative terms have been the norm, like “junk” to describe the issuers of high yield debt, and “chasing yield” to describe the behavior of investors (like the author) who focus on maximizing and compounding cash distributions as their main source of investment return, rather than relying on market growth.
The reality is that many high yield asset classes represent a more conservative bet on corporate performance than buying the same companies’ stock, and may be expected to perform better than equity through crises like the one we are currently experiencing. If you think about what an investor is “betting on” when they buy stock versus when they buy debt (loans and bonds) of a company, this becomes clear. When you buy stock, you are betting that a company will grow its earnings, thus becoming more valuable in the future than it was when you bought it. If its performance merely remains the same, and it continues in business but doesn’t grow at all, then its stock won’t become any more valuable and its market price will likely either (1) fall, because investors will be disappointed and sell it, or (2) remain flat, if it pays enough of a dividend (4 or 5%, perhaps) that some investors will hold it just for its income.
High yield debt pays interest in the 6, 7 or 8% range (sometimes higher), and investors collect the interest and get their principal back (i.e. win the bet) whether the company grows its earnings or not. All the company has to do is survive; in other words, pay its debts and stay in business. Corporate managements have lots of incentive or “skin in the game” in the form of their jobs, salaries, bonuses, stock options, etc., to keep their companies alive, even in bad times. This ability to “hunker down” and pay off by merely surviving is what makes credit-oriented investments, like high yield debt and other fixed income asset classes that pay high yields, arguably safer than equity investments, especially during times of economic uncertainty or potential recession like we are going through now.
As they consider both asset classes – debt and equity – investors should never forget that every time you buy a company’s stock, you are taking BOTH the equity risk (will the company grow?) and the credit risk (will the company pay its bills and survive?). Obviously if a company doesn’t first pay its bills and survive, then there is no way it can grow, because it would go bust and its equity would be worthless. Many investors insist they would never buy high-yield debt because it is “too risky,” but happily buy and hold mid-cap and small-cap stocks, which are virtually all non-investment grade companies and therefore the same cohort of companies that issues high-yield debt. That means every investor in small-cap and mid-cap stocks is a “high yield” investor, whether they realize it or not.
High yield debt demonstrated its resiliency during the crash of 2008. The default rate for US companies reached about 10%, but because loan and bond investors recover much of their principal, even when the debt defaults, the actual portfolio losses for holders of high yield bonds and loans averaged only about 2.5% for loans (because they are secured by collateral) and about 6% for bonds (which are unsecured). While that would have wiped out a portion (almost half) of a year’s interest income for loan investors, and most of a year’s interest income for a high yield bond holder, it would have left principal intact. Moreover, investors were able to reinvest their principal repayments in healthy loans and bonds that were selling at the time at around 50 or 60 cents on the dollar, boosting yields and scoring capital gains in later years.
Obviously, investors have to do what fits their own risk/reward comfort level. But it is important to look beyond the label on investments, and when investors delve into what is really under the hood of many “high yield” investments, they will find solid asset classes that have performed well for buy-and-hold income investors with a long-term perspective.