Michael Milken, the junk bond king, pictured in 1989 before he was sent to prison
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In the 1970s, corporate bonds rated below investment grade by one of the major credit agencies were considered virtually untouchable by serious investors. They were typically issued by “fallen angels”, companies that had fallen on tough times, and were pejoratively called “junk”.

But by the 1980s, large numbers of these bonds were being issued and they have now become an integral part of the global financial system, helping thousands of companies fund themselves across the world.

The global junk bond market currently stands at more than $2tn and, to underscore its rehabilitation, it is now most often referred to as “high yield”, to accentuate the higher returns they offer, rather than the poorer investment grades they are awarded by rating agencies who perceive them as at higher risk of default.

The initial spark that led to high-yield bonds’ makeover came from a now defunct US investment bank called Drexel Burnham Lambert, which Michael Milken, a senior Drexel executive, transformed into a junk-bond powerhouse in the late 1970s and 1980s. He helped turn these high-yield bonds into highly tradeable loans to companies that would have struggled to raise money from traditional sources such as blue chip banks and pension funds.

However, one of the reasons that controversy still lingers over the high-yield bond market is that corporate raiders and private equity firms used money raised by Drexel to usher in the era of leveraged buyouts — using borrowed money to buy companies, often using the target company’s assets as collateral for the loan. (Mr Milken himself ended up spending time in jail for securities law violations.)

Ratings

High-yield bonds are rated Ba1 or lower by Moody’s and BB+ or lower by Standard & Poor’s and Fitch. Investment-grade bonds are rated Baa3 or higher by Moody’s and BBB- or higher by S&P and Fitch

Private equity firms still constitute an important part of the high-yield bond market, but it is nowadays far broader, more diverse and less controversial. Companies that rely on the market include Reynolds American, the second-biggest US tobacco company; auto giant General Motors; Premier Foods, the British food company behind brands such as Mr Kipling cakes and Bisto gravy; American-Italian carmaker Fiat Chrysler; and Fresenius, the world’s biggest dialysis company.

But are these bonds suitable for retail investors? The returns are certainly attractive. One of the aspects that Mr Milken realised and loudly trumpeted many years ago was that despite the fact that low-rated bonds do default more often than high-grade ones, the average returns are so much higher that investors with a broad portfolio of high-yield corporate bonds usually end up making more money than in safer bonds.

Over the past two decades, the Barclays US Corporate High Yield index has on average returned 7.5 per cent annually, comfortably more than the broader Barclays Aggregate’s 6.5 per cent annualised return achieved with investment-grade bonds (those with a BBB-, or Baa3, rating or above).

Moreover, while high-yield bonds are more volatile than more highly rated corporate debt issued by the likes of IBM, Apple or Siemens, they tend to be less turbulent than equities. The S&P 500’s annualised total return is 9 per cent over the past two decades, but it has proven significantly choppier than bond markets.

Gershon Distenfeld, head of high yield at AllianceBernstein, admits that junk bonds are unlikely to replicate their long-term average performance in the coming years, given the phenomenal run of the past few decades, which has driven yields to near record lows, but argues that the outlook is still rosy.

“At the end of the day we’re investing in contracts. As long as these companies make good of their obligations you’ll get a positive return,” he says.

The trick, however, is to stay away from companies that might go bust. Standard & Poor’s recorded 25 defaults by non-investment-grade companies in the first quarter of 2015 and most analysts are expecting more casualties — especially in the shaky energy sector, which has been rattled by tumbling oil prices.

Avoiding these pitfalls is something most individual investors outsource to a fund manager. While bonds trade like equities, for the most part they cannot be bought on an exchange and the minimum denominations can start as high as $200,000.

Luckily, there are now plenty of dedicated high-yield bond fund managers who will happily deal with ordinary investors.

Lipper, a data provider, estimates that there are more than 1,000 junk-focused mutual funds around the world, compared with 516 a decade ago and just 143 in 1995. EPFR Global, another data provider, says almost $140bn flowed into these funds between the start of 2009 and the end of April 2015.

Investors who do not want to hand over fees to a bond fund manager can now also make a bet on high-yield debt through exchange traded funds (ETFs). These low-cost, easily tradeable products aim to mimic the performance of an underlying index, such as the S&P 500, the FTSE 100, or junk bond indices.

There are concerns, however, that these junk bond ETFs are riskier than they might appear, given that they are a liquid, tradeable security that seeks to replicate the performance of an index of bonds that often trade extremely infrequently. In times of turmoil that may lead to painful dislocations where the price of the ETF might not reflect the net asset value of the fund — although analysts say such discrepancies are likely to be temporary.

Of course, investors should not plough all their savings into junk bonds just because the returns are on average higher than on government or safer corporate debt and smoother than with stocks. Even high-yield bond fund managers stress that an allocation to their industry should only be a part of an overall portfolio that includes equities and safer assets such as government bonds.

And some high-profile fund managers warn investors should be wary of the asset class altogether — at least for now. Jeffrey Gundlach, the founder of bond house DoubleLine, recently pointed out to his clients that the high-yield market has never experienced a “secular”, or longer-term, fundamental, rise in interest rates. “When the Fed raises interest rates it is not safe to hold high yield,” he has warned.

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Exchange traded funds have flexibility and offer low costs, but investors need to be aware of risksMinimum investments could traditionally have exceeded $5m, excluding all but the wealthiestHedge funds vary in style and can offer generous returns, but high fees could short change investors
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