Latest posts by Wanderer (see all)
- The Yield Shield: Putting it all Together - April 16, 2018
- The Yield Shield: Dividend Stocks - April 2, 2018
- Friday Reader Case: How Should I Position My Portfolio For Retirement? - March 30, 2018
I’ve been lumping bonds together into one asset-class tracked by a broad ETF like VAB or BND, but the truth is the bond market is a bit more complicated than that.
Usually, when people talk about bonds, they’re talking about those issued by the government. These are seen as ultra-safe and unlikely to default, since the government can always raise taxes to pay off bondholder’s interest payments. These are also the assets that tend to go in opposite directions of stocks. When the stock market rampages ahead, money flows out of bonds and into stocks to capture the gains, and when stock markets tumble money flees back into the safety of government bonds.
However, those aren’t the only bonds out there.
But before we get into those, let’s talk about how each bond’s risk level is determined.
What Is a Bond Risk Rating?
When people walk into a bank to get a line of credit, the bank takes a look at the person’s job situation, their savings, and their credit score to determine how financially healthy they are. A guy with a good credit score and a full-time job is going to be more attractive than someone who’s unemployed and living in their parent’s basement. Their credit-worthiness then determines how much money they can get, as well as what interest rate they will pay. A good credit rating means you’ll qualify to borrow more at a lower interest rate. A sucky one means you can borrow less (or not at all) and if you do, you’ll have to pay through the nose to get it.
Same thing happens with a bond. When a bond gets issued, independent rating agencies like Standard & Poor, Moody’s, and Fitch evaluate a company’s financials and determines how likely that company will be able to pay the interest to future bondholders. They then assign a rating to that bond, which then determines how attractive that bond will be to investors.
A bond issued by the US government would be rated AAA (though I think that got downgraded to AA+ after that whole fiscal cliff debacle in 2011). A bond issued by Morgan Stanley currently has an A+ rating. United Airlines has a BB-.
Think of a bond’s risk rating as the company’s credit score. And just like a person’s credit score affects the interest rate you can get from a bank, a company’s bond rating affects the interest rate they can get on the open bond market. A company with a high bond rating can borrow with a lower interest rate, so their bonds will have relatively lower yields. A company with a crappier bond rating needs to pay a higher interest rate to attract buyers, so their bonds will have relatively higher yields.
You’ve probably noticed a recurring theme in our articles about Preferred Shares and REITs. The key to increasing your yield is to pivot into riskier assets, and bonds is no different.
You can check what the credit quality of a bond ETF by looking at the ETF’s website. For an ultra-safe Vanguard Treasury bond ETF like VGIT, for example, you can click over to Vanguard’s site, open up the “Portfolio & Management” tab and scroll down to find their bond breakdown.
We can see here that this ETF is almost 100% US government, which would make sense since the ETF is called the Vanguard Intermediate-Term Treasury ETF. This fund also has a bond yield of 2.6% as of the time of this writing.
If we wanted to up this yield, we need to up the risk level. To do that, we need to look in Corporate bonds.
Corporate bonds are basically just bonds issued by companies like Apple or Morgan Stanley rather than governments. These are by definition more risky than governments since it’s more likely for a company to go bankrupt than the entire US government, so we can expect their bond yields to be higher. For an example of an ETF that invests in this space, we just need to click around Vanguard’s site until we find a Corporate Bond ETF. Here’s one called the “Vanguard Total Corporate Bond”, VTC.
Clicking into it, we can find this ETF’s bond rating breakdown.
This ETF holds almost no government bonds, but has mostly bonds rated A or BAA. As a result, its bond yield is 3.3% vs the government bond ETF’s yield of 2.6%.
The actual ETF I own in this space is the Canadian equivalent iShares Canadian Corporate Bond ETF, XCB.
|Vanguard Total Corporate Bond ETF||VTC||3.3%||0.07%|
|iShares Canadian Corporate Bond ETF||XCB||3.1%||0.4%|
As usual, I’m not recommending either of these funds for your personal situation, these are just the ETFs I used to illustrate how corporate bonds work.
Though that being said, I’m surprised by how low the fees are on Vanguard’s Corporate Bond ETF. Mine is 0.4%! Yeesh. If I was American, I’d consider switching over.
Despite the fact that Corporate Bonds are riskier than government bonds, this asset class still puts a limit on how risky they’re willing to go. Standard & Poor’s risk scale considers everything from AAA down to BBB- “Investment Grade.” Everything below that (BB+ downwards) is considered speculative.
So Morgan Stanley (A+) would be considered a Investment Grade while United Airlines (BB-) would be considered Speculative.
That’s where High-Yield Bond ETFs come into play. These ETFs actively invest in speculative and really risky bonds in the hopes that the company can actually, you know, pay the interest they promised and not default.
However, I’d be really careful with these ones. The less polite name for High Yield Bonds is Junk Bonds. In fact, one of the biggest ETFs in this space, the SPDR Bloomberg Barclays High Yield Bond literally has the ticker symbol JNK.
So…at least they’re owning it, right?
Anyway this asset class I do own myself but I don’t think it’s for everybody. Back when I first bought into this space, it was paying around 7% yield. But in Canada a lot of the the junk bonds were issued by oil companies, so when the oil crash hit in 2015 and oil fields were closing down left and right, my Junk Bonds really started living up to their less polite name. They got crazy volatile, and as companies starting going under my yield got cut to around 5%. Nothing else cut their yields, so I’m not sure I’d be in this space again if I had to do it over.
Fortunately, I limited my exposure to High Yield to around 5% of my total portfolio, so it didn’t blow me up too badly, but over time I’m planning to gradually sell off this allocation and move it into regular corporate bonds. At 7% they seemed pretty attractive, but at 5% not so much especially since preferreds are paying close to that anyway.
So that’s Corporate Bonds and High Yield Bonds for you. Does anyone own either of these? Any interesting experiences with Junk bonds? Let us here it in the comments!
Want to learn how to replicate our retirement portfolio? Check out our FREE Investment Workshop!
Join our Chautauqua family in Greece:
Want a once-in-a-lifetime experience with a group of exceptional people who get you? Click here to learn more. UPDATE: Chautauqua is 100% SOLD OUT! Click here to sign up for the waiting list! Click here to sign up for next year's mailing list!