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Why You Should Think Twice about High Yield Bonds | Common Sense Investing - YouTube
Channel: Ben Felix
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At a certain point, good old stocks and bonds
might start to seem a little bit boring.
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There has to be more out there, especially
when you start to build up substantial wealth.
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These other types of investments are often
referred to as alternatives.
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They sound much more exciting and exclusive
than stocks and bonds, and are typically sold
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as having higher potential returns or diversification
benefits that plain old stocks and bonds can’t
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offer.
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As Warren Buffett explained in his 2016 letter
to Berkshire Hathaway shareholders:
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“In many aspects of life, indeed, wealth
does command top-grade products or services.
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For that reason, the financial “elites”
– wealthy individuals, pension funds, college
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endowments and the like – have great trouble
meekly signing up for a financial product
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or service that is available as well to people
investing only a few thousand dollars.”
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Alternative investments are a broad category,
so I have split this topic up into multiple
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parts.
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I’m Ben Felix, Associate Portfolio Manager
at PWL Capital.
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In this episode of common sense investing
I will tell you why you should think twice
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about owning high yield bonds.
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In our low-interest rate world, investors
tend to seek out the opportunity to earn higher
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income yields from their investments.
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Two of the most common ways to do this are
through high-yield bonds and preferred shares.
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High yield bonds are riskier bonds with lower
credit ratings and higher yields than their
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safer counterparts.
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Standard and Poors rates all bonds between
AAA, the highest rating, and DD, the lowest
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rating, based on the bond issuer’s ability
to pay back their bond holders.
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High yield bonds have a rating of BB or lower,
defined by Standard and Poors as “less vulnerable
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in the near-term but faces major ongoing uncertainties
to adverse business, financial, and economic
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conditions.”
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Remember that you typically hold bonds in
your portfolio for stability.
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High yield bonds are too risky to serve this
purpose.
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In fact, a 2001 study by Elton, Gruber, and
Agrawal found that the expected returns of
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high yield bonds can mostly be explained by
equity returns.
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In other words, high yield bonds contain much
of the same risk as stocks.
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Only 3.4% of high yield bond issuers have
historically been unable to pay back their
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bond holders, but when they are unable to
pay, bond holders have typically recovered
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a little less than half of their investment.
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It is true that, in isolation, high yield
bonds have had high average returns in the
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past.
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However, including high yield bonds in portfolios
has been less exciting.
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In a 2015 blog post, Larry Swedroe compared
four portfolios, one with all of its fixed
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income invested only in safe 5-year treasury
bonds, the other three with each an increasing
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allocation to high yield corporate bonds.
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He found that while the portfolios with high
yield bonds did outperform by a narrow margin,
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between 0.2 and 0.5 percent per year over
the long-term, they did so with significantly
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higher volatility than the portfolio containing
only treasury bonds.
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On a risk adjusted basis, the high yield bonds
did not add value to the portfolio.
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In Swedroe’s book The Only Guide to Alternative
Investments You’ll Ever Need, he writes
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“Investing in high-yield bonds offers the
appeal of higher yields and the potential
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for higher returns.
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Unfortunately, the historical evidence is
that investors have not been able to realize
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greater risk-adjusted returns with this type
of security.”
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In his book Unconventional Success, David
Swensen, the chief investment officer of the
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Yale Endowment, similarly denounces the characteristics
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of high yield bonds, writing that "Well-informed
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investors avoid the no-win consequences of
high-yield fixed-income investing."
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On top of all of this, high yield bonds are
tax-inefficient.
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They pay relatively high coupons, which are
fully taxable as income when they are received.
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As an asset that behaves similar to stocks,
high yield bonds are a very tax-inefficient
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way to get equity-like exposure.
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High yield bonds do have some proponents.
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Rick Ferri, a well-respected evidence-based
author and portfolio manager, does include
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high yield bonds in his portfolios.
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I do not recommend high yield bonds in the
portfolios that I oversee.
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If you do choose to include high yield bonds
in your portfolio, they should only make up
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a small portion of your fixed income holdings.
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Due to the risk of default and relatively
low recovery rate, it is also extremely important
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to diversify broadly with a low-cost high-yield
bond ETF.
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I would never suggest purchasing individual
high yield bonds.
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Join me in my next video where I will tell
you why preferred shares don’t get you any
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preferential treatment.
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My name is Ben Felix of PWL Capital and this
is Common Sense Investing.
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I’ll be talking about a lot more common
sense investing topics in this series, so
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subscribe and click the bell for updates.
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I want these videos to help you to make smarter
investment decisions, so feel free to send
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me any topics that you would like me to cover.
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My name is Ben Felix of PWL Capital and this
is Common Sense Investing.
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I’ll be talking about a lot more common
sense investing topics in this series, so feel free to
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send me future topics that you would like me to cover!
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