High yield bonds have been referred to as “junk bonds,” but that is not the case—they can be a savvy investment for investors who are conscious of the risks involved with these types of bonds.
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High yield bonds are bonds issues by companies who have credit ratings below investment-grade. Investment-grade companies are international firms with enormous revenues. Because of their size, there is no chance of default, the failure to make scheduled interest or principal payments. This makes their credit ratings extraordinarily high, even higher than the credit ratings of the U.S. government.
High-yield bonds are issued by companies that are below investment-grade. These companies are smaller, and do not have the stability of investment-grade rated companies. These companies may have unstable business models or plans, significant amounts of debt, or may have had negative earnings. All of these factors increase the likelihood of default. The higher the risk of default, the lower a company’s credit ratings. In order to compensate for this higher level of risk, these lower-rated companies must offer higher yields on their bonds in order to attract investors. As with all investments, higher risk correlates to higher potential investor returns.
Investors may choose to invest in high yield bonds through mutual funds or exchange-traded funds (also known as ETFs), the biggest concern is not a default. For high yield bonds, the historical default rate is around 4% annually. At this rate, most ETFs and funds will not be significantly affected by defaults. The bigger concern for high yield bond investors who invest through mutual funds or ETFs is the instability of the bonds when compared to other bonds. Though many high yield bonds have consistently performed well in the long term, high yield bonds are highly sensitive to market downturns. This mercurial nature can result in rapid and significant drops in the value of the bonds. In 2008, the high yield bond market lost more than a quarter of its value. For investors who can not withstand a potential, extremely dramatic short-term loss, high yield bonds are not a recommended investment solution.
In terms of returns, the long-term performance of high-yield bonds has been very successful. One ten-year indicator showed an average annual return of over 10%. This rate was higher than any other area of the fixed income market with the exception of emerging market bonds. For comparison, investment-grade bonds returned over 5%, and stocks returned around 6.5%. These results have been relatively consistent over a period of nearly 30 years.High yield bonds tend to perform best during times of economic expansion and high investor confidence. When the economy is doing poorly, high yield bonds tend to also perform poorly. Generally, interest rate movements do not have as dramatic an impact on high yield bonds as they do on other types of bonds.
Investors who tend to choose high yield bonds are often looking for a compromise between stocks and bonds. Although they are fixed income securities, high yield bonds are much more sensitive to dramatic fluctuations and tend to behave more similarly to stocks than to investment-grade bonds.
Investors who are looking for high returns and have the ability to withstand long-term investment (at least three to five years) are the best candidates for the purchase of high-yield bonds. It is also essential that high yield bond investors are able to withstand the risk of a volatile investment. Investors with low risk tolerance or who are looking for short-term investments are not good candidates for the purchase of high-yield bonds.
Investors who decide that high yield bonds are a wise investment choice for their individual situation are able to purchase the bonds through mutual funds or exchange-traded funds. High yield bond purchasers also have the option to buy through a broker, but any investor who chooses to invest through a broker must diligently research and prepare before making any purchases.
About Lawrence Meyers
Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at firstname.lastname@example.org.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.