In a report titled Know your security when chasing yield, Morningstar notes that investors are “often unknowingly” moving higher up the risk curve while pursuing better returns through the use of high-yield debt and hybrid securities.
Neither of these options are “meant for the faint-hearted”, says Morningstar, given that both come with notable risks.
Among these, the report notes that default rates on high-yield bonds have been increasing in recent years and are presently at their highest since 2009.
“Too many times investors fall into the trap of assuming that by virtue of an investment being pure debt, it is less risky,” the report said.
The authors of the report, Morningstar’s head of credit research John Likos and associate credit analyst Michael Murphy, go on to add that hybrid securities shouldn’t be considered fixed income “when it comes to the asset allocation process”.
This sentiment is shared by the Australian Corporate Bond Company, which argues hybrid securities “are not defensive in shielding portfolios” from market downturns.
Morningstar also noted in a second report, the Fixed Interest Sector Wrap-up, that bonds “still play a valuable role in a portfolio”, even under current conditions.
“The portfolio insurance provided by bonds and their inverse relationship to interest rates and the economic cycle remains valuable. When the economy and stock market take a dive, central banks usually cut interest rates, which is good news for bonds,” said the report.
Mr Likos and Mr Murphy suggest that it’s “impossible to say that one class of security in its entirety represents better value than another”, and that rather than using one in place of another, they should “co-exist in a well-diversified portfolio”.
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