The key to a proper investing strategy includes understanding the inherent perks and risks involved. High-yield bonds are no exception.
Various risks are involved in this type of investing, but there are also advantages to including high-yield bonds as part of your investment portfolio.
What are they?
High-yield bonds (a.k.a. “junk bonds”) are high-paying bonds with a lower credit rating than investment-grade corporate bonds, treasury bonds, and municipal bonds.
These bonds are commonly defined as debt obligations with a bond rating of Ba or lower on the Moody’s rating scale or BB or lower on the Standard and Poor’s scale.
Bonds with these ratings are referred to as “below investment grade,” which means that the company is not financially secure. A risk exists that the company could miss making an interest payment or default on paying back the principal amount on time.
Such companies have to pay higher interest rates on their loans, which in turn means that lenders earn a greater financial gain (higher return) in the end.
Advantages of high-yield bonds
High-yield bonds generally produce higher returns than CDs and government bonds.
Their performance also has a low correlation with investment-grade bonds or stocks, which means that bonds with a higher yield are less vulnerable to interest rate shifts.
High-yield bonds can also add financial security to your portfolio by protecting you from significant losses. For example, if a company goes bankrupt, bondholders are paid first in the liquidation process before preferred and common stockholders.
Risks of high-yield bonds
High-yield investing has a higher risk of unpredictability (or volatility—the degree of change in bond prices over time) and default. The corporate loan default rate is pretty low (approximately 3 percent in 2018), but corporate indebtedness is rising around the world.
One thing to note is that fund managers can manipulate the default rate for high-yield mutual funds, as they can dump bonds before they default and replace them with new ones.
If you discover in your research that the fund’s turnover is high, it is likely that near-default bonds are being replaced frequently.
Another issue is that rising interest rates and a weak economy can worsen yields. For example, as interest rates rise, the price of bonds goes down. High-yield bonds are not as affected by short-term rates, but they tend to follow long-term interest rates closely.
Investment planning alternatives
Leveraged bank loans: These types of loans have a higher interest rate to reflect the higher risk posed by borrowers. The higher interest rate means lenders get a larger return on their investment.
Emerging market debt securities: These funds invest most of their assets in securities from countries classified as emerging. Usually, these debt securities are cheaper than their U.S. counterparts and are a higher risk/higher reward than markets in developed countries.
High-yield mutual funds or exchange-traded funds (bond EFTs): An ideal and less risky way to invest in high-yield bonds. These funds offer a variety of low-rated debt obligations for your portfolio, and diversifying reduces the risk that comes with investing in struggling companies.
The bottom line
Despite the inherent risks, high-yield bonds provide benefits to consider for your investment portfolio, as they offer opportunities for high income (higher return) and can reduce the overall volatility of your portfolio.
