Higher yield usually means greater risk. Frequently, investors are mesmerized by high-yield bonds and ignore the reason for the high yield. Higher yield bonds mean that there is a greater chance the bond might default. Investing in a bond fund or an exchange-traded fund diversifies away some of the risk, but won’t completely protect you from defaults on principal or interest payments.
Who issues high-yield bonds?
Small corporations that have yet to prove themselves in the marketplace or larger businesses in financial distress are the two most likely types of companies to issue high-yield bonds. Although risky, high-yield bonds can provide diversification in an investment portfolio when combined with other investment vehicles.
Benefits of high-yield bonds
During periods of economic distress, high-yield bonds have often outperformed stocks. The greater volatility of high-yield bonds over other segments of the bond market offers investors high income and potential capital appreciation over the long term. However, high-yield bonds aren’t short-term investments, and anyone who is not prepared to stay with them over the long term should avoid them.
Impact of interest rates
High-yield bonds have a tendency to go against current wisdom about rising interest rates causing a decline in the bond market, and they seem to be affected less than the rest of the bond market by changes in prevailing interest rates.
Default rates
The volatility of high-yield bonds is a real concern for investors. When the market turns sour, high-yield bond values can fall rapidly. Over the past three decades, high-yield bond issuers have had a default rate of around 4.5% a year. In bad times, that rate was around 12% and in good times it was under 2%. Therefore, high-yield bonds aren’t for the faint of heart or those unwilling to monitor their portfolio’s performance and economic conditions on a continual basis.
After all, there is a reason high-yield bonds are referred to as “junk bonds.”
For more useful information about bonds, read What You Need to Know Before Buying Bonds.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published December 10, 2014.