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Staying defensive in the junk bond market
In the uncertain world of the coronavirus, even with several vaccines on the way, avoiding excess risk is more important than ever. As a result, one might assume that relatively higher quality issuers would trade at a premium over those with lower quality balance sheets as investors vie to own the highest quality assets. Surprisingly, however, today higher quality assets arguably look cheap when compared with riskier issuers relative to historical averages. Consequently, and given the context, having a defensive mindset within high yield makes more sense than ever. Luckily, for investors looking to play it safe, the opportunity set in the high yield market is greater than ever and likely growing.
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A word on risk
Investing involves risk; loss of principle is possible. There is no assurance that downside protection will be achieved.
Credit risk may be heightened for the portfolios that invest a substantial portion of their assets in “high yield” debt or loans with low credit ratings. These securities, while generally offering higher yields than investment-grade debt with similar maturities, involve greater risks, including the possibility of interest deferral, default or bankruptcy, and are regarded as predominantly speculative with respect to the issuer’s capacity to pay dividends or interest and repay principal. Companies that issue high yield debt or loans tend to be highly leveraged and thus are more susceptible to the risks of interest deferral, default and/or bankruptcy.
Securities of below investment grade quality are regarded as having predominately speculative characteristics with respect to capacity to pay interest and repay principal, and are commonly referred to as junk bonds. Issuers of high yield securities may be highly leveraged and may have fewer methods of financing available. The prices of these lower grade securities are typically more sensitive to negative developments, such as a decline in the issuer’s revenues or a general economic downturn, than are the prices of higher grade securities. The secondary market for high yield securities may not be as liquid as the secondary market for more highly rated securities, a factor which may have an adverse effect on a portfolio’s ability to dispose of a particular security. There are fewer dealers in the market for high yield securities than for investment grade obligations. The prices quoted by different dealers may vary significantly and the spread between the bid and ask price is generally much larger than for higher quality instruments. Under adverse market or economic conditions, the secondary market for high yield securities could contract further, independent of any specific adverse changes in the condition of a particular issuer, and these instruments may become illiquid. As a result, a portfolio could find it more difficult to sell these securities or may be able to sell the securities only at prices lower than if such securities were widely traded.
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