Years from now, we'll tally up all the ways this extended period of low interest rates has warped the investing experience.
One to add to this list is the minor mania surrounding high yield bonds. Get this: high-yield bond ETFs currently have yields in the low 4 per cent range. For this modest return by historical standards, investors are expected to invest in companies that are financially too frail to qualify for the investment-grade credit rating that says your interest payments and return of principal on maturity are basically secure.
A widely diversified government and investment-grade corporate bond ETF might get you a yield of a little more than 2 per cent. Is the extra return from high-yield bonds fair compensation for the extra risks? More and more market-watchers are saying no.
The most dangerous risk with high-yield bonds is default, but a recent report in Barron's said the default rate in the U.S. market is at a five-year low of 1.7 per cent. Here's why you can't be complacent about this default rate: It's more a reflection of the low-rate world we live in today than it is an indicator of the health of companies issuing high-yield bonds. Some high-yield issuers are living on a life-support system of low rates. When rates rise, we could see the default rate rise as companies struggle to cope with higher borrowing costs.
This risk is particularly relevant in light of the fact that the booming high-yield market has allowed progressively weaker companies to issue bonds. With investor dollars flowing steadily into high-yield mutual funds and ETFs, there has been a ready market for these lower-quality bonds.
You'd be selling something that is currently working just fine if you decided to get rid of your high-yield exposure. The BMO High Yield U.S. Corporate Bond Hedged to CAD Index ETF (ZHY) had a total return of 3.1 per cent for the first quarter of 2014, and an annualized two-year gain of 9.6 per cent. There's virtually nothing in the bond world today that has the potential to offer returns like this in the years ahead, so you may want to look at the stock market if you get out of high yield. Stocks may not be a shining bargain, but you can make a case that they're more attractive than high yield bonds today.