Many feel that issues rated lower than investment grade should be eschewed as those bonds could be headed toward default or some other unpleasant and costly credit event
When I began managing bond portfolios, high-yield debt was often dismissed with the pejorative “junk bond” label. My initial role when starting my career as an analyst at a ratings agency was to monitor the lower-rated bond holdings in the investment-grade category to ensure they didn’t get downgraded to non-investment grade.
Ironically, this irrational fear adds to the attractiveness of the asset class. In aggregate, and over significant time periods, high-yield corporate debt trades at more attractive yields than their credit risk would justify. This has a lot to do with the fact that so much of the investment public fear them. And, more so in the present than past, public pension funds were prevented from holding them. Pension funds were required to sell corporate holdings that dropped to non-investment grade.
The second assumption is based on a misperception of risk and return. Investors often argue that stocks have unlimited upside while corporate bonds mature at par. This logic forgets the fact that unless there is a disastrous credit event, bond investors will get all their money back in most cases and will be ahead of equity investors if there is a default. Bondholders usually get paid first out of asset sales. More importantly, if a company collapses, so does its stock price.
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