Hunting for Yield: Are Junk Bonds Worth the Extra Risk?

When the market dropped and interest rates went down, we went searching for yields… primarily in junk bonds.

Our investment strategy for early retirement includes dedicating a portion of our portfolio to income-producing investments. These assets will provide a passive income stream that we’ll use to offset expenses in early retirement. We’re hoping this strategy will help reduce the withdrawals (i.e. sales) we need to make in the early years. The longer we can defer taking the entire amount of our safe withdrawal rate, the better off our portfolio will be in the long run. 

Disclaimer: This blog post reflects our personal opinions and investment strategy and is not intended to be investment advice. Please perform your own research and consider seeking the advice of a professional before making significant financial decisions.

Where we hunt for higher yields

We seek yield in two ways: dividends from stocks and interest from bonds.

Dividends are my favorite way to earn passive income, since they currently receive preferential tax treatment that limits taxes to 0% – 20% (depending on your income levels). While we invest in some dividend paying stocks, our primary dividend plays are Vanguard High-Yield Dividend ETF (VYM) in our taxable portfolio and Vanguard Equity Income Admiral Shares mutual fund (VEIRX) in our retirement portfolios. We also invest in REITs, which pay robust dividends, though without the tax advantages. I’ll write more about our dividend strategy in a future post.

The second way we seek passive income from our investments is by investing in bonds. We’re cautious investors, so want to make sure our investment portfolio is appropriately diversified. This means including a portion of our investments in bonds which, conveniently, are also yield-producing assets. Higher quality bonds are less volatile than stocks and offer price stability during recessions, which becomes important once you start living off your investment portfolio. 

Bonds pay interest on a monthly basis, which are typically taxed as ordinary income. The exceptions to this rule are municipal or government bonds, which may be exempt from federal and/or state taxes.

Let’s move on to the topic of this article: Bonds

Playing it “safe”

Treasury and government bonds are considered some of the safest investments because they are either directly or indirectly backed by the U.S. Government. And if that fails, we’re all in trouble.

Treasury and government bonds play an important role in your portfolio, by protecting it against dramatic market swings (downward). However, the days of 4%+ yields are long gone, and they are no longer an attractive investment for fixed income. At least, not currently.

Corporate bonds

If fixed income is your goal, you may want to focus your bond investments on corporate bonds. Corporate bonds are backed by individual companies, so they often offer higher interest rates. However, they also carry a higher risk.

You can estimate risk levels by looking at an issuer’s credit rating, which provides an indication of the default risk associated with the offering. The higher the credit rating, the lower the risk the payee won’t be able to pay. This lower risk usually results in a lower yield.  

Although there is a wide spectrum of credit ratings, corporate bonds are usually classified as either investment grade or high yield (or “junk bonds”).

Junk bonds have a higher default risk, which is why they usually pay a higher interest rate. If a bond payer defaults, it will significantly hurt the price of the bond, since cash flows generally cease and a portion of the principal balance might be uncollectible. This makes junk bonds incredibly risky to invest in individually. I don’t recommend it.

IF you’re interested in seeking a higher yield (with moderate risk), you might instead look to a high-yield bond mutual fund. These funds offer greater diversification, since investments are spread over hundreds of issuers and debt instruments.

It’s important to note that corporate bonds, especially junk bonds, tend to act more like stocks during market recessions. You should be comfortable watching your portfolio balance drop significantly if you’re thinking of moving beyond the safer bond funds.

Are junk bonds worth the extra risk?

If you were just concerned with collecting the highest fixed income return for your money, you’d select the highest paying bonds you could find. But it’s important to remember that the higher interest rates are due to a higher risk of default.

So, the question is: Are the higher yields paid by junk bonds worth the extra risk they carry (when compared to other bonds)?  

It’s a good question, and honestly, there probably isn’t a “right” answer. What you choose will depend on your risk tolerance and goals.

When we began searching for additional fixed income beyond dividends, we decided to jump into corporate bonds… both investor grade and junk bonds. Previously, our bond exposure was limited to total bond market funds within our retirement accounts.

We made most of these investments during the 2020 recession, after bond prices had been crushed, so future appreciation also played a role in our initial decisions.

It wasn’t until after we’d poured several thousand dollars into junk bonds, and bond prices began to recover, that we began to question whether the additional yields were worth the risk.

Where we invested…

Here’s are some key metrics of the three corporate bond funds we’re invested in (all Vanguard, because we like low fees). We also have some investments in municipal bonds, but that is primarily for tax purposes, so I won’t get into that today.

_{*Note: “Current Yield” represents the “SEC 30-day yield” from Vanguard’s website as of 6/14/2021. This metric is a standardized calculation of recent yields. The Trailing-Twelve Month (TTM) is another popular metric that’s useful in evaluating an investment, but can be misleading in volatile market conditions or times of increasing/decreasing interest rates (like this past year) due to the lag. The TTM shows higher yields and a more significant spread between VWEHX and VTC, which makes sense given the declining interest rates, increasing prices, and higher risk of default for riskier assets over the past year.}

The primary difference between these three funds is the quality of bonds they’re invested in.

The Total Bond ETF invests the majority of its assets in treasury or government-backed bonds (~65% of the portfolio at May 31, 2021), with the rest in investment grade bonds.  

The Total Corporate Bond ETF invests solely in investment grade corporate bonds, with less than 1% of its assets in other bonds.

The High-Yield Corporate Fund, on the other hand, specifically focuses on bonds which fall below investment grade. As of May 31, 2021, only 5% of the portfolio was invested in bonds with a government or investment grade rating. In order to seek balance between risk and returns, the fund does focus investments towards “B-class” rated bonds, which is the tier below investment grade.

Analyzing the Risk vs. Reward

Let’s digest the metrics above. The market always fluctuates, so all we can do is consider the information we have available today.

Volatility

If you are a short-term or jittery investor, you may want to consider price volatility when assessing if junk bonds are worth the extra risk.

When it comes to volatility, the higher the risk, the more closely bonds will align with stocks and plummet during a market recession or depression.

Of these, junk bonds will usually suffer the most dramatic swings, which makes sense, since issuers with lower credit ratings are statistically more likely to default in bad times.  

The table below shows the volatility (or spread) between high and low prices during a few recent 52-week periods as obtained or calculated from performance statistics on Vanguard.   

What surprised me in the table above, is how closely VTC and VWEHX tracked to each other in terms of volatility. It seems like all corporate bonds were punished nearly equally by the market during the most recent COVID-19 driven recession.

Meanwhile, BND, which has the majority of its assets in government bonds saw the smallest fluctuation. I included Vanguard’s Total Stock Market ETF (VTI) above just to add a reference point for stocks.

Returns & Yields

When you consider the returns and yields associated with each fund above, you may notice that both corporate bond funds performed better and have better yields than the total bond fund. The differences are meaningful between the first fund and the second two.

However, when you compare the Total Corporate Bond to the High-Yield (or Junk Bond) funds, the difference is much smaller. If you had $200,000 invested in either of these funds, the difference in annual interest received would only be $660 using current yields. This difference would obviously grow as the amount invested increased, but it wouldn’t be wise to tie up too much of your investment portfolio in low quality bonds regardless. Either way, it seems like you could eek out a tiny bit more yield by investing in higher risk bonds.

However, if you compare the Total Bond Market to the Total Corporate Bond, the difference in yield on a $200,000 investment would be $2,640 using current yields. And that doesn’t include any difference in appreciation, which was a couple percentage points higher in recent years. You can collect that additional yield for only a moderate amount of additional risk. Heck, even Vanguard includes them in the same risk category.

As noted above, yields and the spread between various investment types changes frequently, so you may wish to follow and/or evaluate funds over a period of time before investing significantly.

Our Takeaway

Only you can decide if the amount of additional yield and potential upside associated with junk bonds is worth the extra risk for your portfolio.

Personally, after analyzing the risks and returns, I no longer think junk bonds are worth the risk. The spread was more attractive when we first invested, but less so now. While we aren’t selling our junk bond positions, I’ve backed off of investing more money into those funds.

That said, I do think the increase in yield associated with corporate bonds (within a diversified portfolio) vs. government bonds is worth the extra risk, at least based on most recent performance, current yields, and our personal situation. We’ll direct the money we allocate for bond investments towards corporate bond funds going forward, though will reassess in 6 or 12 months.

What do you think? Are junk bonds are worth the extra risk?

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