Do you want to invest in bonds with higher interest rates? If yes, high-yield bonds can be your thing. However, these high-interest rates come at a higher risk. Different aspects affect this investment decision. So, without further ado, let’s get into it!
What is a High Yield Bond?
A high-yield bond, or junk bond, is a type of corporate bond that provides a high-interest rate. These bonds have lower credit ratings. Hence, they are riskier investments than investment-grade bonds.
Capital-intensive firms or start-ups issue these debt bonds to get money in a short period, and in return, they provide higher interest rates. These bonds have lower credit ratings due to the poor credit quality of the issuer.
Simply put, a start-up may not have money, so they need debt. However, they make their interest rates high so investors can lend them money. They promise to pay principal value and interest at maturity. However, some of these companies work and make a profit, and some of them don't. Therefore, there is a high risk in investing in such bonds.
There are two categories of bonds:
- Non-investment grade bonds
- Investment Bonds
High-yield or junk bonds fall into the first category due to lower credit ratings from credit agencies like Standard & Poor, Fitch, or Moody.
Further, you can breakdown high-yield bonds into two categories:
- Fallen Angels : Because the issuer has a low credit rating, fallen angels can become junk bonds and may result in loss. Think of it as a start-up that never made a profit and went bankrupt. That's why, before investing in such companies, you should understand their business idea and analyse it.
- Rising Stars : Improved credit quality score of a company or issuer makes a junk bond a rising start. Even with high risk, you might get that high interest from these bonds. You can think of these as successful start-ups. These are the best high-yield bonds that may result in profits.
Advantages of High-Yield Bonds
Although these bonds are called junk bonds, they are not fruitless investments. Their credit rating is lower due to their current credit quality, but they may improve over time and yield high gains. In fact, in many cases, start-ups or such corporations do well and pay back higher returns than traditional bonds. Also, these are less volatile than stock market investments.
However, investing in high-yield bonds comes with a potential risk. Therefore, investors study these companies, and their business idea, weigh the advantages and disadvantages of the issuer, and then make a wise investment.
1. Higher Pay-out
If a high-yield bond pays out, it will always be more than a traditional investment-grade bond. Because they have a lower investment-grade rating, they have to give higher ROI. So, if the corporation's profits increase, the investor gets more pay.
2. First Pay to Bondholders
If a company fails to make any progress, the bondholder gets its principal amount back before the stockholders during the liquidation of the company's assets. Therefore, many investors consider these safer investments because even if they don't get anything, their money is safe in a high-yield bond.
3. More Dependable ROI
The pay-out of these bonds remains consistent unless the company defaults and pays a higher ROI. On the other hand, stock payouts are based on the company's performance.
4. Recession Resistance
Some companies without investment-grade ratings can become recession resistant as they boom in recession. It makes your bonds safer during financial downtime.
5. Diversified Portfolio
Many stock investors invest in high-yield bonds to diversify their portfolios and reduce overall financial risk.
Disadvantages of High-Yield Bonds
1. Higher Volatility
These bonds are more erratic or volatile than traditional bonds and the stock market. Therefore, investing in them is considered riskier.
2. Default Risk
The company with a lower credit rating may not raise over time and become a fallen angel. That way, you won't get the interest or other returns.
3. Liquidity Risk
As these bonds are more liquid, if you decide to sell them, you won't get the true value. It means you won't profit by selling these bonds when you want to change your investment decision.
4. Interest Rate Risk
When the market interest rates rise, the prices of bonds decrease. The interest rate can change anytime.
How to Invest in High-Yield Bonds?
You can directly buy high-yield bonds from the broker-dealers or buy them indirectly through mutual funds or ETFs with a high-yield bond fund focus. The investment manager or adviser selects these bonds for the portfolio. Investing in junk bonds with mutual funds and ETFs are not related to liquidity and similar risks.
Before investing, you must understand the issuer's policies and similar factors. Here is what you must check:
- Payment Terms : There are many payment terms and rules in interest payment. You must read these clauses and understand when the company can skip the interest and more.
- Covenant Protections : These are rules about protecting the bondholder from changes in the interest rate and principal value. By reading these documents thoroughly, you will understand your right and bond holder's policies. These are extensive yet crucial documents that you must go through before investing. The more covenant protections, the better your chances of you coming out of the investment safe. Considering these policies is a must because these companies can become falling angels, and you might be clueless about your next move in such situations.
- Call Provisions : The company can pay the amount of the bond in cash whenever they want to with these call provisions. Do understand the call terms and similar provisions before investing.
The Bottom Line
If you always have safer investments and want to help start-ups or companies that you think will boom over time, you can invest in high-yield bonds and get the most out of it. However, you must study the company's background, plans, business ideas, and similar factors.
Some other non-risky investments can be savings bonds and real estate. With comparative study and analysis, you can find what works for you. Join Compound Banc and learn these different ways to increase your wealth.