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Is the economy on the brink of a bond blowup?

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Much has been written and discussed about the significant cash inflows to bond holdings during the past 30 years as interest rates have steadily crept ever lower. Even more has been written of late about the risks of significant loss inherent in the quite possibly over-inflated bond market, especially when interest rates reverse their downward trend.

Following June's uptick in rates and downtick in some bond yields, now seems as good a time as any to further investigate the various types of bonds out there and what might serve to protect an otherwise conservative portfolio that relies on investment grade bonds for lower volatility and steady income.

Breaking down the bond markets

Investment grade bonds have historically been considered a lower-risk asset class relative to equities or high yield bonds. With the prospect of increasing interest rates on the horizon, investment grade bonds, especially those with longer terms to maturity, could suffer from significant spikes in volatility.

In "A Case for High Yield Bonds," Russell Research notes that in this rising rate environment, one which truly has not been experienced for more than 30 years, high-yield bonds provide an attractive benefit to a diversified portfolio.

How has a traditionally volatile asset class, one often referred to as "junk bonds," become more respected in an increasing interest rate environment? To answer this, let's consider what exactly high-yield bonds are and how they work.

Junk no more?

High-yield bonds are simply bonds that have been issued by companies or entities with lower credit ratings than their investment grade peers. Due to the increased risk an investor incurs by lending money to a company or entity with a low credit rating, that investor requires a higher interest rate, or yield, in order to justify purchasing the bond. They are rated by credit ratings agencies as below investment grade (i.e. BB/B/CCC); still, they have historically provided substantial and reliable interest income.

Russell contends that, due to the higher income these instruments produce, high-yield bonds offer a buffer against price volatility. Moreover, during economic downturns, high-yield bonds have historically seen greater returns than even equities.

Whose default is it?

One of the substantial risks in the high-yield bond markets is the risk of the issuer's default, though many economists have noted that, since 2008, many companies, even those issuing high-yield bonds, have put themselves to work deleveraging and cleaning up their balance sheets.

Since the notable corporate defaults of late 2008, the ratings agencies have caught quite a bit of flack for maintaining high ratings for some companies even while those companies defaulted. Russell points out that in the wake of this high-profile embarrassment, the ratings agencies may be skewing unnecessarily conservative in their estimation of companies' default risks.

Just consider the fact that junk bond default rates in 2010 and 2011 averaged approximately 2 percent, which falls well below the historical average 5 percent default rate, yet the risk spread for these instruments have not budged accordingly with their apparently decreased default rate.

On a sea of rising rates

Now back to the reason why a portfolio over-ridden with investment grade bonds may need a little doctoring: rising rates.

High-yield bonds have historically floated on a sea of rising interest rates rather than sinking like investment grade bonds, making them worth consideration for some investors who may choose to liquidate investment-grade bonds prior to significant rate movements.

Their low sensitivity to rate increases relative to much of the fixed income market can be explained by the fact that increasing interest rates often coincide with economic expansion. During economic expansion, high-yield bonds may experience spread tightening when rates rise, because investors may be willing to accept greater credit risk in a rising interest rate environment.

This, in combination with the fact that these bonds' higher yields can provide a cushion or buffer to rising rates, makes them viable contenders for some investors' portfolios in the months and years ahead.

What this means for you

Of course, none of this should serve as financial advice as any investor must discuss his or her personal financial situation with an investment adviser or financial planner prior to receiving the most suitable recommendations specific to him or her.

High-yield bonds are no silver bullet to rising interest rates, but in combination with a number of creative strategies that may include some variety of securities, like preferred shares of stock and other less-interest-rate-sensitive instruments, could serve as viable protective measures worth taking before the bond markets go bust.

Anthony M. Conte is managing partner at Conte Wealth Advisors with offices in Camp Hill, and Fort Myers, Fla. He has a master's degree in financial services and the certified financial planner certification. He welcomes your emails:

Registered representative securities offered through Cambridge Investment Research Inc., a broker/dealer, member FINRA/SIPC. Investment advisor representative Cambridge Investment Research Advisors Inc., a registered investment adviser. Cambridge and Conte Wealth Advisors LLC are not affiliated.

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