Junk Bunds Are a ‘Different Animal.’ Here’s How Advisors Are Taming Them

What’cha gonna do with all that junk, all that junk inside your trunk?

Yeah, we realize the Black Eyed Peas weren’t talking about junk bonds when they popularized that lyric in 2005, but think of it as double-entendre. New research from The Wall Street Journal looking at the asset class over the past 50 years found results that make the question worth asking in a financial markets context. Analysts reported that while high-yield fixed income performed much like equities, surging in bull markets and lagging in recessions, they also returned almost 7.5% annually since the 1970s. Those returns averaged nearly 9% when the economy boomed, but fell to negative 2.5% in downturns. It’s an interesting play, advisors said, especially for clients who are looking for yield but prefer to find it in more defensive asset classes, like fixed income.

“The 50-year outperformance story is real, and any honest advisor has to acknowledge it,” said Matt Chancey, a CFP and founder of the advisory practice Tax Alpha Companies. 

Check the Junk Drawer

Junk debt doesn’t exactly scream core portfolio, but there are a number of use cases that can benefit clients. While they’re not a primary tool, they’re not inherently bad, Chancey said.  “People hear ‘bond’ and assume defensive,” he said. “Junk bonds are a different animal that happens to share the same family name.”

In a portfolio where the client doesn’t have access to private credit, junk bonds can fill a real slot. But, private credit has a similar risk profile, better yields, no daily mark-to-market volatility and is more tax-efficient. “Public junk bonds are the retail-accessible version of that exposure,” he said, adding that he usually prefers ETFs in a tax-advantaged portfolio. Remember, yields can be taxed as ordinary income. “Putting junk bonds in a brokerage account is one of the more common avoidable tax mistakes I see,” he said.

The equity-like behavior of high-yield bonds can prove problematic. Clients with long horizons that can absorb the drawdowns can be prime candidates, but not so much for clients using fixed income for ballast. “I use them sparingly and intentionally,” said Mark Stancato, CFP, of VIP Wealth Advisors. He allocates between 3% to 5% within the fixed-income sleeve of a 60/40 portfolio. “Where they tend to work best is in stable or improving economic environments,” he said. “Where they disappoint is exactly when investors need bonds to behave defensively.”

Interest rates also play a role, according to the WSJ report:

• With rising interest rates, the average high-yield debt fund delivered an annualized return of just under 3% with about 6% volatility. 
• Those same funds returned almost 12% with just over 11% volatility when rates were falling.

Junk Happens. Junk bonds are often thought of as a stock proxy with higher returns, but less risky than stocks, said J. Christopher Boyd of the Wealth Enhancement Group. He uses ETFs or mutual funds that offer broad diversification, solid management and ease of trading.

“Management is essential and well worth it in this category of investing,” he said. His firm has a more cautious economic outlook today, and is moving away from the category in the near term. “Like most things in investing, it’s rarely an all-or-nothing decision,” Boyd said.