Chasing Super High Yields Can Burn Your Portfolio

The high-yield side of the bond market has been enjoying a good year. It has been such a good year that a very high-risk type of bond has made a reappearance: the pay-in-kind (PIK) toggle note. Be wary of its high yield as you would a siren song.

PIK notes give the bond issuer the right to issue additional securities instead of making cash interest payments. It is akin to a new homeowner increasing the size of their mortgage instead of making the monthly mortgage payment. PIK toggle notes allow the bond issuer to choose between making their interest (coupon) payments with cash or by issuing additional securities. The latter gives the borrower greater flexibility with each payment.

The latter is the arrangement the Calderys Group used. The thermal protection products manufacturer recently sold $300 million of four-year PIK toggle notes with a yield of 11.75%. If it chooses to issue bonds instead of making a cash payment, those additional notes would yield 12.50%. Calderys was the first company to complete a PIK toggle offering since 2021.

Why would a company issue notes at such a high yield? It couldn’t get adequate financing otherwise. Just like credit card companies charge higher interest rates to people with bad credit scores, bond traders demand high yields when they sense high levels of risk.

S&P assigned the notes a CCC+ grade. This poor quality rating is assigned when the bond issuer is perceived to be highly vulnerable to not making interest payments.

Bond traders seemed to agree with the S&P assessment. Axios says Calderys issued the PIK toggle notes at $0.98 on the dollar, resulting in a yield of 12.4%.

It’s not just high-yield bonds that are risky. High-yield stocks are risky too—especially those with the highest yields.

I screened for exchange-traded stocks with yields ranking in the highest 1% of all stocks. Our Stock Investor Pro database and stock screening program identified 82 such stocks. Their yields are 10.9% and higher. Half either aren’t profitable or have earnings per share so small that their payout ratios are essentially meaningless. The median Z-Score of these companies is 0.22; scores below 1.80 indicate that a firm is headed for financial distress.

These are not companies operating from a position of financial strength. Their yields are very high because investors fear what could happen to the dividend and the companies themselves. The short-term advantage of getting the juicy dividend could easily be wiped out by a drop in the share price or a bankruptcy filing.

In investing, chasing after very high yields is like playing with fire, you may get (badly) burned.