Looking for a way to profit outside of stocks? Widening high yield bond spreads offer a way to do just that, even for investors with little-to-no experience or a small account.
Bond Prices, Yields, and Their Relationship
Before you can profit with bonds, you must first understand the relationship between prices and yields.
When a bond is initially issued, it comes with a fixed interest rate, also known as its coupon rate. This rate does not change over the life of the bond. However, the price of the bond in the secondary market can fluctuate due to changes in interest rates, credit ratings, and other factors.
When interest rates rise, existing bond prices fall. This is because investors are no longer willing to pay as much for a bond that offers a lower yield than newly issued bonds.
Conversely, when interest rates fall, existing bond prices rise. Investors are now willing to pay more because the bond offers a higher yield than newly issued bonds.
Here’s an example from a pretend business that we’ll call XYZ Company:
Let’s say XYZ Company issues a bond with a 5% coupon rate. Sometime later, however, market interest rates increase to 6%.
To compete with newly issued bonds offering a 6% yield, the price of the existing XYZ Company bond in the secondary market will decrease. That lower price makes it more attractive to potential buyers.
The inverse relationship between bond prices and yields is one of the most important concepts to understand when investing in bonds. Just remember this: prices and yields move in opposite directions.
What are High Yield Bond Spreads?
High yield bond spreads refer to the difference in yield between high yield bonds (also known as junk bonds) and government bonds, typically U.S. Treasury bonds. This spread is a reflection of the market’s perception of the risk associated with high yield bonds.
When the spread is narrow, it suggests that investors are confident in the economy and willing to take on more risk.
When the spread widens, it indicates that investors are becoming more risk-averse, often due to economic concerns or market turbulence.
You can monitor high yield bond spreads for free using the Federal Reserve Economic Data (FRED) online database. The graph below shows how the spread has widened and narrowed over time. The shaded areas indicate U.S. recessions.
Profiting from High Yield Bond Spreads
As of this writing, the spread is 4.81. If, however, the U.S. enters a recession, that spread will likely widen. It will also be your opportunity to profit.
Here’s why and how:
- When the high yield bond spread widens, it could indicate a buying opportunity. This is because high yield bonds are becoming cheaper relative to government bonds, making them more attractive to investors seeking higher returns.
- As the economy improves and investor confidence returns, the high yield bond spread is likely to narrow. This is the ideal time to sell because prices will have increased, providing you with a profit.
Investing in High Yield Bonds through ETFs
Buying individual corporate bonds can be challenging and risky for retail investors. Upfront costs can be high, and not all bonds are available through every broker. Investing in individual bonds can also expose you to company-specific risks.
A more accessible option is investing in high yield bond exchange-traded funds (ETFs). These funds hold a diversified basket of high yield bonds, reducing the risk associated with individual bond investments. A popular example is the SPDR Bloomberg High Yield Bond ETF (JNK).
TL;DR
- High yield bonds give you the opportunity to profit outside of stocks and provide you with asset diversification.
- If stocks crash, keeping a portion of your portfolio in bonds can reduce your losses.
- Bond prices and yields are inversely related. When one goes up, the other goes down.
- Buy when the high yield bond spread widens, and be prepared to sell when it narrows.
- Use ETFs, such as JNK, to gain diversified exposure to high yield bonds.
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I am not a financial advisor, and I do not provide financial advice. This article is for informational purposes only. Read the full disclaimer for more details.