One commonly used indicator of risk when investors are choosing which bonds to buy is credit rating. 3 major credit ratings agencies – S&P, Fitch and Moody’s – use a standardised set of rules to assign each bond a rating that indicates how likely you are to get your initial investment and returns in full and on time.
Bonds with a credit rating from AAA to BB are called investment-grade bonds. These bonds are at the lower risk end of the spectrum. At the other end are bonds rated BB to D which are called high-yield bonds (or junk bonds). These bonds give a better rate of return and the trade- off for this is that they are also riskier. Make sure you do some research into the risks and rewards of the bonds before investing your money.
Although high yield bonds may seem off putting, due to their lower credit rating, there is a vast offering and many market of buyers and sellers in this category. In fact some of the biggest, well established Fortune 500 companies have in the past and continue to issue junk grade bonds.
In a low interest rate environment there are so few lucrative options for our money – money in a savings account or investment grade bonds will generate very little return. In addition, in a low interest rate environment, typically, lending to businesses will be in smaller volumes. This means businesses profits will not be as good and if you invest in equities your returns may not be high either. In these conditions junk bonds may be appealing as they offer a high rate of return when almost no other investment does. To some investors, if given the opportunity, investing in Fortune 500 companies with a high rate of return seems like a clear choice for their money – however the majority of investors still hesitate and beware the junk bond risks.
Junk Bonds – Beware!
This is most likely because of historical price behaviour of junk bonds. Junk bond prices can be very volatile – this means the price can swing up and down a lot. Some investors find this kind of price behaviour unpleasant – one day you’re making lots of money on your investment, the next you’ve lost a lot of money. The other concern is that some companies issue junk bonds and they are not committed to returning initial investments from the outset – this is called market abuse.
You might buy a junk bond and that company may have already decided in advance that they would use your investment and declare bankruptcy before it is time to return your initial investment. You could lose all of your money with a higher probability with high yield bonds. In fact many Wall Street professionals will argue that the negative outlook on high yield bonds persists because of market abuse and questionable practices of financial and business professionals.
Why Invest in High Yield Bonds?
However, in some cases, junk bonds do not necessarily deserve the negative reputation that they have accumulated. In fact, adding high-yield bonds to a mixed portfolio may reduce total portfolio risk. This is through the benefits of diversification – all your eggs are not in one basket. The returns on high-yield bonds do not move exactly in line with either investment-grade bonds or stocks – we say they are not strongly “correlated”.
This low correlation means adding high-yield bonds to portfolio can be a good way to reduce risk and boost returns. Another benefit is that because the yields on junk bonds are higher than investment-grade one they are not as vulnerable to interest rate shifts. Also, if you are seeking higher yield for your fixed-income portfolio, high-yield bonds can be a sensible choice as they have typically produced better returns than government bonds and high rated corporate bond issues.
There are genuine situations in which good companies experience some phases of financial difficult – a one off bad year for profits can lead to a company’s bond ratings to be downgraded to a level lower than investment grade. In this situation high yield bonds can be a good opportunity for investment.
Another option investors have when looking for high yield investments in a low interest rate environment is emerging markets. Investing in emerging markets stocks and bonds is cheaper than when looking at developed nation’s securities. This is because you are exposed to a much smaller market. Emerging markets currently account for a big portion of high-yield markets on a global scale. Although emerging markets can appear to offer high rates of return on your money this comes with a higher risk to your money.
Investing in these regions can expose you to a wide range of unexpected risks – the government could collapse due to political vulnerabilities, the company could go bankrupt at a higher level of probability. Corruption, instability, poor infrastructure and many more conditions of doing business in emerging market regions lead to risk trickling through the economy, through the banking and financial sector and can impact your investments negatively.
The ability to give you high levels of income return and the ability to reduce overall portfolio risk are good reasons to consider high-yield investments. Before investing in high-yield bonds, you should make sure that you are aware of the risks. Do some research on financial advisory, and you will find the right investment for you and your circumstances.
If you are new to bonds, read more on Bonds 101 and How to Get Started on Bonds.
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