Wednesday, May 30, 2007

High Yield Bond Risk

Although I don’t plan on making fixed income part of my retirement plan I thought that I’d highlight some interesting facts from an article I read recently by Neil Reynolds on

In his article Mr. Reynolds makes the case for investing in a basket of high-yield non-investment grade bonds instead of investing in a single triple A rated bond. He states in his article “it is a fact that most high-risk borrowers make their mortgage payments. Therefore you can achieve - depending on the bundle of mortgages you buy - a risk not much greater than a triple-A security. A portfolio of non-investment-grade bonds offers risk-adjusted returns greater than that of an investment-grade portfolio.”

Just something to think about before you buy your next AAA rated 5% government bond.


Anonymous said...

It's a very interesting point about most high-risk borrowers making their mortgage payments. I'd like to read more about it. Do you have a direct link to this article?

Anonymous said...

Here is the link to his article:

Thicken My Wallet said...

Wouldn't the risk factor really depend on what bundle of mortgages being offered in the bond? Something which I understand you can't see?

Anonymous said...

sorry financial the link didn't display properly. I'll try again.

S. B. said...

I'm not sure that the fact that "most high-risk borrower make their mortgage payments" is a very compelling argument. Mathematically, if you had a portfolio of junk bonds with a YTM of 11% and 90% of the bonds (i.e. "most") made their mortgage payments, but the other 10% defaulted, your return would be zero, which would be much worse than the risk free rate.

I'm not dismissing high-yield as a worthwhile asset class. I'm just pointing out that it only takes a small percentage of defaults to substantially affect your total return. Thus, when the article states that "it is a fact that most high-risk borrowers make their mortgage payments", that's really telling you very little about the risk/reward trade-off.

These days, junk bonds tend to be fairly well correlated with stocks. Conceptually this makes some sense, as junk bond holders are next to last in line, just ahead of stockholders.


Nice info on bonds.