Smart401k Blog

Over the past several months we’ve fielded calls from Smart401k clients concerned about investing in bonds. The main reason: interest rates are at historically low levels and seem to have only one way to go – up. While this concept is generally true, the fact is all bonds are not created equal. First, let’s recap the basics so we can move on to how this fits with a retirement plan strategy: when interest rates go down bond prices typically go up – a seemingly good thing for the bond investor. When interest rates go up the price of bonds will fall.

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This year has been a rather tumultuous year for investors, with the past month being extremely volatile. The Dow Jones Industrial Average is down more than 35% year-to-date as of Oct. 24. I believe fear has been responsible for a significant portion of the market’s return as investors are overly focused on the health of both our financial system and the economy. I like all of the advisors at Smart401k read and learn as much about the market as we can. One of the things that I have noticed has been the steep selloff in the high yield bond market.

For those of you that are not familiar with high yield bonds (aka junk bonds), they are corporate bonds that have been assigned a credit rating below investment grade by Moody’s or Standard & Poor’s (The two main credit rating agencies).  Bonds with a credit rating of BBB or lower from S&P and Baa or lower from Moody’s are considered high-yield bonds.  Because of their lower credit rating, these bonds generally pay a higher yield than investment grade bonds.  (For more information on bonds click here)

Similar to the stock market, the high yield bond market has been plagued by fear.  This fear has resulted in a steep decline, approximately 25% YTD as of Oct. 24^th, in the Merrill Lynch High-Yield Master II Index, a common benchmark for the high yield bond market.  According to Moody’s, the market has priced in a rise in the default rate to almost 20% which would top the record of 15.4% set during the Great Depression in 1933. The uncertainty in the market has also pushed the yield spread over U.S. Treasuries from around 3% a year ago to over 15%.

A number of bond fund managers, including Dan Fuss from Loomis Sayles, have observed the decline as well and see the current market as an investment opportunity. Mr. Fuss recently gave an interview with Morningstar and said that the current bond market is the best buying opportunity he has seen since 1974.

Please note, I am not advocating or a recommending high yield bonds but rather wanted to write about an observation of recent events. Please feel free to contact us if you have any questions regarding high yield bonds or if you have any questions about your account.

Buck Wendel, Investment Advisor