With a total return of 15.6 percent in 2012, the Bank of America High Yield bond index logged an attractive overall level of performance.
Over the same period, the Dow Jones Industrial Average of large capitalization stocks managed a total return of 10.2 percent. A much more diversified and less credit risk-intensive aggregate bond index recorded a total return of 4.4 percent in 2012.
With interest rates continuing to hover near all-time lows and with very limited room to fall much lower, future price-appreciation potential for fixed coupon bond investments due to decreasing interest rates is somewhat limited.
Incremental yield on fixed income securities above the yield of U.S. government bonds is relatively minimal on investment grade bonds. The market yield to maturity on the broadly diversified, aggregate bond index is currently about 1.6 percent. At the same time, the market yield to maturity on the High Yield bond index is currently about 6.7 percent.
Some narrowing of credit spreads is possible, which would result in further price appreciation on these fixed-income securities. However, credit spreads are generally deemed relatively narrow on a historical basis. Any material deterioration in the overall economic climate would imply incremental default risk for the issuers of many fixed-income investments.
This economic uncertainty would generally result in an increase of the market credit spreads and cause the prices of these existing bonds to fall. Given higher credit risk bond issuers are represented in the High Yield index, any general credit spread widening would be magnified in these higher risk securities.
Looking back only a few years, the High Yield bond index demonstrated some very volatile return patterns. In 2008, this bond index recorded a total return of a negative 26.4 percent. Significant concerns about the ability of these riskier issuers to make coupon payments and ultimately return principal resulted in significant negative performance.
For investors insightful enough to own the bonds represented by this index in 2009, prices rebounded strongly. A total return of 57.5 percent rewarded these investors.
The aggregate bond index had total returns of 6.2 percent and 5.2 percent in 2008 and 2009, respectively. With a much lower credit risk profile and significantly more issuer diversification as compared to the High Yield index, the aggregate index returned a much more stable profile over that specific time period.
As with all investments, past performance is no guarantee of future returns. Risk tolerance, liquidity needs, time horizon and a range of other key factors should be considered before putting funds at risk, whether in stocks or bonds.
Kirby Brown is the CEO of Beneficial Financial Group in Salt Lake City.