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Scrounging for Yield Is Dangerous

High-yield bonds are expensive, but if you absolutely demand high income, here's a closed-end fund to consider.

Samuel Lee, 07/08/2014

A version of this article was published in the May 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

For the past year or so, I've warned ad nauseam that stretching for yield is dangerous. When your Aunt Marys and Uncle Joes are climbing onto the bandwagon, it's time to hop off. Of course, many readers still want income assets and have duly ignored my finger-wagging. Rather than preach abstinence, I've come around to the notion that it's better to teach safe, um, income investing.

Yield is like oxygen: When it's there, people behave sensibly and take its existence for granted, but as its level drops, they start getting woozy, then lose their critical faculties, and then fight to get more before passing out. We're at the stage where investors are losing their heads--maybe past it.

Yields are low. Not only are they low, but risky bond yields are too low compared with equivalent-duration Treasuries. The yield difference between a credit bond and a Treasury is called the yield spread. Because lots of bonds have embedded options that can affect their cash flows, analysts like to look at the options-adjusted spread, or OAS.

The table below tells the story. It shows various yield statistics for U.S. corporate bonds, grouped by credit quality. The Effective Yield column shows yield adjusted for options. The next column shows OAS. Percentile shows where today's spreads rank since the end of 1996; lower values indicate tighter spreads. Historical Annual Credit Loss indicates how much bonds of that credit quality have lost on average after recoveries are taken into account. Credit Premium is the OAS minus the historical annualized credit loss; it can be interpreted as the expected additional return for bearing credit risk. Expected Nominal Return is calculated by subtracting annual credit losses from effective yield.

The table indicates that the lowest- and highest-quality bonds are trading at tight spreads relative to history--spreads associated with boom times when lots of dumb decisions are made. Investors are not being compensated much for taking on credit risk. Bonds rated CCC and under, for example, have been more expensive only 9% of the time since 1996. Spreads this tight coincided with periods of irrational exuberance, like 2005-07.

There are a couple of concrete investment implications I'll explore. But before that, I want to kill a bad justification for junk bonds' thin spreads: Default rates are low and are projected to stay low; therefore, such bonds still offer attractive loss-adjusted yields.

Samuel Lee is an ETF Analyst with Morningstar.

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