The Worst Deal in All of Finance

"Return-free risk" was a catchphrase you'd hear all the time during the 2010s...

Investors were talking about U.S. Treasury bonds. And they weren't exaggerating... The phrase was exactly right.

You see, at the time, 10-year government bonds frequently paid less than 2% per year. So after inflation, you were locking in losses for a decade. Plus, you could lose a lot of money if rates went up quickly (as we've seen in recent years).

In other words, government bonds were a bad bet for investors. And it was obvious to anyone paying attention.

A similar story is playing out today in a different part of the bond market... But this time, investors are getting an even worse deal. In fact, folks who buy now are accepting one of the worst risk-reward setups we've seen in decades.

Let me explain...

The worst deal in finance today isn't completely return-free. But what little return you'll earn is dripping with risk.

I'm talking about high-yield bonds. They're the riskiest bonds because they're issued by companies with low credit ratings. So these companies have a much higher risk of not being able to pay their debts.

High-yield bonds also pay better interest than their more creditworthy counterparts. The extra interest is supposed to compensate investors for the higher risk of default...

But right now, you're not getting much in additional interest with high-yield bonds.

To see this, I looked at the interest-rate spread between high-yield bonds and U.S. Treasury bonds. The benchmark of this spread is the ICE Bank of America U.S. High Yield Index Option-Adjusted Spread.

Today, high-yield bonds pay an interest rate that's just 3.26 percentage points higher than that of government bonds. That's one of the lowest spreads we've seen since the Federal Reserve began hiking interest rates in early 2022. Take a look...

The spread on high-yield bonds ballooned alongside recession fears in 2022. It jumped from around 3 percentage points to roughly 6 percentage points in the first half of that year – and for good reason...

Remember, by definition, companies issuing high-yield debt are in the worst financial shape. If a recession hits, they'll be some of the first to suffer. So the fear of a looming recession increases spreads as folks demand higher yields.

Now, we haven't gotten that recession yet. And spreads have collapsed to near multiyear lows.

That means the largest high-yield bond exchange-traded fund – the iShares iBoxx High Yield Corporate Bond Fund (HYG) – pays a yield of just 6%. A few years ago, investors might have been OK with a 6% yield. But these days, it's not a lot of compensation to take on the risk of the high-yield bond market.

The economy still hasn't cracked like many believed it would. But recessions are inevitable... One will show up eventually.

When that happens, yields will soar. High-yield bond prices will take a serious hit (since yields and prices move in opposite directions). And if we see yields spike from today's incredibly low spreads, those losses will be painful.

What's more, if you want a yield right now, you don't have to take on much risk to get it...

One good outcome of the Fed's massive rate hikes is that money-market funds now pay more than 5%. That's a risk-free 5%-plus yield.

When the Fed starts cutting rates, those money-market yields will fall. But for now, if you want strong yields in the years ahead, you can easily lock up your money in a five-year certificate of deposit paying a 4.6% annual yield.

We're out of the "zero-percent world" that dominated the 2010s. But that doesn't make every fixed-income investment a smart bet...

And in the case of high-yield bonds, buying now is just about the worst deal you can find in all of finance.

Good investing,

Brett Eversole

Further Reading

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The media is badmouthing one tech titan's latest product. Some folks are dumping shares as a result. But for contrarian investors, this sets up a rare opportunity – because one of the world's best businesses is now on sale... Learn more here.