The Federal Reserve’s zero-interest rate policy is now well into its fifth year, probably far longer than most – if not all – investors were expecting. This persistence of low interest rates has pushed many investors to stretch for greater yield from their bond investments. One way to achieve higher yield is to take on more credit risk through the purchase of lower-rated bonds. Many argue that higher-yielding bonds also provide some diversification benefits. While this is true, the low average correlation between lower-rated bonds and stocks has a nasty tendency to dramatically increase at exactly the wrong time, such as when equity risk shows up. As my colleague Jared Kizer and I discuss in our book, The Only Guide to Alternative Investments You’ll Ever Need, this should come as no surprise because high-yield bonds are basically hybrid securities. Some of the risk in high-yield bonds is unique, but much of it can be explained by certain types of risk in common with equities and Treasury bonds. In other words, credit risk is mostly equity risk in disguise. If investors were unaware of this, 2008 should have provided ample instruction.
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