I noticed something peculiar about the markets today…
A type of risky behavior that I haven’t witnessed since my forex trading days.
It’s one of the common pitfalls that forex traders learn about at the very start of their careers.
Yet, somehow, casual investors seem blind to this trap… and flock to it like insects toward the light.
Over the course of the last economic expansion, Federal Reserve (FED) policies created an anomaly—an environment where interest rates stayed too low for too long.
This meant that, suddenly, average investors couldn’t earn the bond yields they were used to. Most weren’t willing to accept that reality and began looking for assets offering higher returns.
As every investor knows, higher return means higher risk.
In forex, this risk comes in the form of leverage. If you increase it, you can get far better returns.
But you also increase the chances of blowing up your account.
Bonds are not immune to this principle. Yet investors, in their greedy quest for higher yields, seem to have forgotten this fact. They are piling their hard-earned cash into junk bonds like there’s no tomorrow.
It’s a classic example of irrational exuberance, and you want to make sure you don’t fall in the trap.
Can Your High-Yield Bond Survive The Next Downturn?
The global economy has been enjoying a post-recession boom, but this market climate will not go on forever.
Unless you’ve been living on the moon for the last year and a half, you know that economic growth around the world is slowing… which means corporate revenues will soon begin to slow, as well.
When you buy a junk bond, you’re lending money to a business that is unable to secure a loan at market rates. Their balance sheets are problematic.
Now ask yourself, how will these companies survive when their revenues begin to fall? And will they have enough cash flow to continue making high-interest payments on the bonds they’ve issued?
The answer to both these questions is that they probably will not.
Don’t Buy Into The ETF Hype
The underlying problem is the lack of research most investors do before investing in junk bonds. They prefer to buy a high-yield bond exchange-traded fund (ETF), thinking that’s a safer strategy.
How is a bag of rotten apples better than a single rotten apple? Either way, you end up hungry. When you buy into an ETF, you may think you’re spreading out your risk across hundreds of high-yield bonds. In fact, you’re buying a bagful of rotten investments.
If you really must buy junk bonds, you’re better off carefully studying a handful of distressed companies to identify the one most likely to make a turnaround.
Make the choice yourself rather than trusting it to an ETF manager. These guys don’t have your best interests in mind. They have goals to reach and quotas to fill, and, most important, they must make their product look sexy, even if that means including investments that don’t make financial sense. Their agendas are different from yours, no matter what their shiny webpages promise.
Unfortunately, all bonds, even high-yield bonds, are perceived to be safe… which is why investors who wouldn’t buy a distressed stock have no problem adding them to their portfolios.
They don’t realize that the nomenclature is different… but it amounts to precisely the same thing.