High-yield bonds have long been a popular source of diversification for long-term investors who seek to maximize yield and/or total return potential outside of stocks.1High-yield issues often move independently from more conservative U.S. government bonds as well as the stock market.
These bonds — often referred to as “junk” bonds — are a class of corporate debt instruments that are considered below investment grade, due to their issuers’ questionable financial situations. These situations can vary widely — from financially distressed firms to highly leveraged new companies simply aiming to pay off debts.
As the name “high yield” suggests, the competitive yields of these issues have helped attract assets. With yields significantly higher than elsewhere in the bond market, many investors have turned to high-yield bonds for both performance and diversification against stock market risks.
These are valid reasons for investing in high-yield bonds, especially long term. But as you read about what these issues could offer your portfolio, it’s also wise to consider how these bonds earned their nicknames.
The Risk-Return Equation
In exchange for their performance potential, high-yield bonds are very sensitive to all the risk factors affecting the general bond market. Here’s a summary of some of the most common risks.
- Credit risk: A high-yield bond’s above-average credit risk is reflected in its low credit ratings. This risk — that the bond’s issuer will default on its financial obligations to investors — means you may lose some or all of the principal amount invested, as well as any outstanding income due.
- Interest rate risk: High-yield bonds often react more dramatically than other types of debt securities to interest rate risk, or the risk that a bond’s price will drop when general interest rates rise, and vice versa.
- Liquidity risk: This is the risk that buyers will be few if and when a bond must be sold. This type of risk is exceptionally strong in the high-yield market. There’s usually a narrow market for these issues, partly because some institutional investors (such as big pension funds and life insurance companies) normally can’t place more than 5% of their assets in bonds that are below investment grade.
- Economic risk: High-yield bonds tend to react strongly to changes in the economy. In a recession, bond defaults often rise and credit quality drops, pushing down total returns on high-yield bonds. This economic sensitivity, combined with other risk factors, can trigger dramatic market upsets. For example, in 2008, the well-publicized downfall of Lehman Brothers squeezed the high-yield market’s tight liquidity even more, driving prices down and yields up.
The risk factors associated with high-yield investing make it imperative to carefully research potential purchases. Be sure to talk to your financial professional before adding them to your portfolio.
1Diversification does not ensure a profit or protect against a loss in a declining market.
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