The term “junk bond” doesn’t exactly inspire a lot of confidence, but the high yields offered by these riskier investments can be tempting. In the municipal bond market, some investors may be tempted to discount the possibility of default given the government-backed nature of the market. But, the turmoil in Puerto Rico is a great reminder that these kinds of defaults do occur and investors should exercise caution when purchasing junk bonds.
Below, we will look at whether or not investors should even consider purchasing junk bonds for their municipal bond portfolio.
Risk-Adjusted Returns
Junk bonds offer higher yields than investment grade bonds in order to account for the greater risk that investors are assuming. If investors account for this risk, they may find some junk bonds actually offer lower risk-adjusted returns than investment grade bonds. It’s important to keep risk in mind when comparing bonds rather than simply looking at yields in order to get a complete picture of how an investment will impact an overall portfolio.
For example, suppose an investor can purchase a risky investment with a 75% chance of paying out $1,000 or a safer investment with a 100% chance of paying out $800. The riskier investment has an expected gain of $750 (1,000 × 0.75), while the investment grade bond has an expected gain of $800 (800 × 1.0). This means that the investor would be better off purchasing the safer asset despite the lower face-value return.
Investors can calculate risk-adjusted returns by:
- Determining the best case, baseline case and worst case scenarios. For instance, a bond might return 100% of face value with interest, 75% of face value with interest or 50% of face value with interest over its lifespan.
- Assign probabilities to each scenario. For example, the bond may have a 90% chance of returning 100% of face value with interest and a 10% chance of returning 75% of face value with interest.
- Multiply the probability by the expected return for each scenario and add these figures together to come up with an overall risk-adjusted expected return.
When calculating these probabilities, investors should incorporate both bond-specific factors, like the issuer’s credit rating, and market-wide factors, such as potential changes in interest rates.
Diversification is Key
The best way to invest in junk bonds without taking on unnecessary risk is to include them as only a fraction of a diversified portfolio. This way, investors aren’t risking their entire net worth if a junk bond defaults, since they will make up the difference in other assets.
The problem is that many individual municipal bonds are denominated in $10,000 increments, which makes it difficult for individual investors to accumulate enough bonds to remain diversified. In addition, individual bonds must be laddered across maturities to ensure interest rate risk is diversified, which requires a certain level of time and expertise to accomplish. These dynamics limit individual bonds largely to high net worth investors and institutions.
Exchange-traded funds (ETFs) are a great alternative for individual investors looking for junk bond exposure. Rather than buying an individual bond for $10,000, investors can purchase shares of a junk bond fund that holds many junk bonds for less than $100. Many broader muni bond ETFs provide exposure to both investment-grade and junk bonds, which means investors can build broad exposure – including junk bonds – in a single investment.
There are many high-yield muni bond ETFs to consider, including:
The Bottom Line
Junk bonds may not sound that appetizing on the surface, but their high yields can help improve a portfolio’s overall risk-adjusted returns. Investors interested in adding a junk bond component to their muni bond portfolio should carefully estimate risk-adjusted returns and ensure that the bonds are added into a diversified portfolio to minimize risk.
