I am often dismayed by how marketers and salespeople attempt to re-brand something and tell you it is new and improved when, fundamentally, it is the same old thing with a new name (the phrase “lipstick on a pig” comes to mind). Just as corporate raiders were re-branded as the kinder and gentler private equity, junk bonds suddenly are called “high-yield bonds” and, viola, it is sold as a whole new product.

WHAT IS A HIGH-YIELD BOND?

High-yield bonds are below investment grade debt instruments issued by businesses that are not rated as “investment grade” by the credit rating agencies, mostly likely because of less than desirable financial statement, who can only raise debt by offering greater than market returns.

What type of returns are we talking about? Typically, a high-yield bond’s attractiveness is based upon how much higher the bond will pay above the  treasury rate.  In good times, the spread may be in mid to high single digits (or in the range of 8-12% return per annum). Merrill Lynch reports that the spread between high yield bond yields and treasury rates is now 17.6%: partially a function of the low treasury rate and the risk premium on the bonds.

If you are pursuing high yields on fixed income instruments, they may be attractive investment products. As with all things though, it helps to understand the risks involved.

WHAT ARE THE RISK FACTORS?

The major risks on high-yield bonds is two-fold. Your first is your typical risk and reward risk. There is a reason why yields are so high. Risk of default is higher than average- and possibly climbing.  Fortune Magazine quotes several people in the industry who believe the high-yield bond default rate is now between 10-15% up from 2-3% a year ago.

The second is more contextual in this economic climate. Are the bond issuers in industries that can withstand this downturn? For example, a high-yield bonds issued by a manufacturing company would not be enticing right now.

Regardless of industry, the larger questions remains how are the companies going to refinance the bonds when they mature in this climate? The issuer/borrower may be able to pay the interest payments to the investor but does it have the ability to pay back principal upon maturity? The troubling aspect of the recent vintage of high-yield bonds is that the use of funds are not for M & A activity- the historical use by private equity- but for operations. Thus, the exit strategy for a capital raise is not even some liquidity event like an IPO or merger.

There’s a newer risk which I like to call re-branding risk. It is still the same old junk bonds but mutual funds have begun to take positions in high-yield bonds in their bond funds, marketing this move as enhancing ROI but not fully alerting the investor of possible downside risk (I can’t blame the financial industry entirely- people keep pushing for higher returns in the abstract without weighing risk). If you understand the risk this is fine but what if you bought a bond mutual fund for capital perservation and the portfolio manager is now buying riskier investments?

If you study even a cursory history of junk bonds, they were instruments typically used by private equity to finance heavily leveraged M&A in the 1980′s and when the 1991 recession under-folded, the junk bond industry cratered.

Is this beginning to sound like a familiar tune?

Here is the final kicker- on a quantitative analysis, one may be better off of increasing your equity holdings over chasing high yield fixed income instruments.

ANY FINAL THOUGHTS?

There is a bailout aspect of high-yield bonds: the United States Government, under heavy criticism, are proposing to sell high-yield bonds backed by all the toxic assets they are buying from the banks as part of the bad bank program announced earlier this month. In other words, a taxpayer backed junk bond program (the math is curious on this- and admittedly I am simplifying this- taxpayer pays up to 40-45 cents on the dollar as taxes to the government to buy toxic assets which it could potentially sell to that same taxpayer at a return of 10-20 cents on a dollar but the taxpayer is 100% on the hook if the asset underlying the bond- the toxic bank- is worth nothing or close to nothing).

High-yield bonds may have a place in some people’s portfolio- if you can tolerate the risk and have hedged against default. But for those seeking capital preservation or safety, a high yield bond (either alone or in a mutual fund) may not be the instrument to help meet your goal and may be a trojan horse in your financial castle.

As always, do your due diligence and don’t rely on the branding alone.