The quest for higher yields is going to end badly for some investors. There is new evidence that some investors are ignoring risks in exchange for quenching their thirst for income.

The latest is junk bonds. Yesterday, the yield of the Barclays US High Yield Index fell to a new record low of 4.96%. It broke the 5% level for the first time in its entire 30-year history on Tuesday. Barron’s noted that prior to this past January, the index’s yield had never fallen below 6%.

Before you add junk bonds to the list of things that aren’t what they used to be, take a step back to consider the broader picture. Yields on the benchmark 10-year Treasury note remain extraordinarily low at 1.81%. The Federal Open Market Committee showed no signs of pulling back on the reigns of its stimulus program when it met last week. Loosening credit standards have made it easier for corporations to issue debt. Lower interest rates, a rebounding economy and cost-cutting measures are reducing the short-term potential for default. All of these factors bode well for high-yield bonds.

Yet, high-yield bonds are nicknamed ‘junk bonds’ for a reason: They are issued by companies with weak credit ratings. These bonds pay higher yields because investors want additional compensation in exchange for accepting the greater potential of a default. Bull markets lull investors into downplaying risks, even though history shows it is dangerous to do so. History further shows that when a flight to quality occurs, high-yield bonds suffer. History will repeat, I just can’t tell you when.

I can empathize with investors who are reaching out to high-yield bonds for reasons of income. Not only are Treasury yields low, but we are also seeing yields on dividend-paying stocks fall as well. In the May AAII Dividend Investing newsletter, we noted that average indicated yields on S&P 500 health care stocks and consumer staples stocks were down 25 and 74 basis points, respectively, from a year ago, as of April 26, 2013.

What has me worried, however, is that some investors are ignoring the risks of higher yields. Getting an extra few percentage points in yield right now may not be enough to offset a large future decline in price. This is particularly the case for companies with high levels of debt and low (or no) levels of free cash flow, regardless of if we are talking about bonds or dividend-paying stocks. Junk bonds carry the additional risks of offering limited upside and being susceptible to changes in the spread—the yield premium investors demand for buying junk bonds instead of higher-quality bonds.

If you are cognizant of and can both financially and emotionally tolerate the risks of high-yield bonds, they are an option for your portfolio. If, however, you think you will be able to get out of them in time, I would tread carefully, because these types of investments can take a bite out of your portfolio.

More on AAII.com

• Corporate Bond Analysis: What to Consider – Portfolio manager Jason Brady explains what to consider when looking at corporate bonds.
• How Credit Ratings Affect Bond Valuations – While going through our archives, I found this 2001 AAII Journal article that explains the impact bond ratings have on bond prices—a timely topic for the current market environment.
• What Do You Think about the Record Low Yield on Junk Bonds? – Tell us on the AAII.com discussion boards.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

First-quarter earnings season begins to wind down with just 11 S&P 500 member companies scheduled to report earnings next week. Included in this group are Dow components Cisco Systems (CSCO) on Wednesday and Wal-Mart Stores (WMT) on Thursday.

The week’s first economic reports will be April retail sales and March business inventories, both of which will be released on Monday morning. Tuesday will feature April import and export prices. The April Producer Price Index (PPI), April industrial production and capacity utilization, the May Empire State manufacturing survey and the May National Association of Home Builder’s housing market index will all be released on Wednesday. Thursday will feature the April Consumer Price Index (CPI), April housing starts and building permits and the May Philadelphia Federal Reserve survey. The preliminary May University of Michigan consumer confidence survey will be published on Friday.

May stock options will expire on Friday.

AAII Sentiment Survey

A jump in optimism put bullish sentiment back above 40% for the first time in nearly two months, according to the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 9.8 percentage points to 40.8%. This is an eight-week high. It is also the first time since March 14, 2013, that optimism is above its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 1.3 percentage points to 31.8%. This is the first time since September 2012 that neutral sentiment is above its historical average of 30.5% on three consecutive weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 8.5 percentage points to 27.4%. This is the lowest level of pessimism registered by our survey since January 31, 2013, and the first time pessimism has been below its historical average since April 4, 2013. Though seemingly low, bearish sentiment is just 3.1 percentage points below its historical average of 30.5%.

Bullish sentiment has risen by a cumulative 21.5 percentage points since bottoming out on April 11, 2013. The rise has put the number of bulls above the number of bears for the first time since April 4, 2013. New record highs by the Dow Jones industrial average and the S&P 500 index, better-than-forecast earnings, signs of continued economic growth and a lack of new bad news are all contributing to the higher level of optimism. This is a cautious optimism, however, as many investors remained concerned about current valuations, the actual pace of economic growth and a lack of progress on key issues by the White House and Congress.

This week’s special question asked AAII members for their opinion of first-quarter earnings. Responses varied with 20% of respondents saying earnings were good, 15% saying results were mixed or so-so, and 14% describing profits as disappointing or weak. Slow revenue growth or the impact of widening margins were cited by 18% of respondents.

Here is a sampling of the responses:

• “Stronger than most felt they would be.”
• “So far, so good. Most companies are meeting expectations.”
• “Earnings are better than revenues suggest they should be.”
• “Earnings were okay, but revenues were weak.”
• “The earnings increase was due to cost-cutting, not top-line revenue growth. This is a bad sign.”