Investors looking for income might be drawn to high yield bonds. High yield sounds like exactly what they’re looking for. However, their desire for yield often leads them to overlook the many risks that surround these investments. Tom and Brendan discuss the risks associated with high yield bonds on this week’s Mullooly Asset Management podcast.
High yield, non-investment grade, junk…all of these descriptions refer to the same type of investment. Bonds issued by companies with poor or shaky credit ratings. These bonds (rated below BBB) offer higher yields than investment grade bonds and treasuries because of the additional risks bondholders assume.
One thing to keep in mind regarding higher yields is that they’re relative. Meaning that when the long term US Treasury is yielding 3.25% (much like current conditions), junk bonds might be yielding 5-6%. Is the risk assumed worth the investment and the relatively higher yield gained? That’s a question investors and their advisors should be examining closely.
The different types of risks that junk bond investors should be considering are credit risk, price risk, and interest rate risk. Credit risk is based on the issuing company’s financial situation. Assuming you hold their bond to maturity, will they be around to pay you? What are their chances of defaulting? A lot of high yield bond issuers have poor or no credit history. That’s why their bonds aren’t investment grade. Price risk comes from the fact that bonds trade by appointment. Meaning that when you want to sell a bond, your broker has to find a buyer for it. This can lead to price volatility, meaning you might not get market value for your bond. Interest rate risk is assumed by any fixed income investor, regardless of whether their bonds are investment grade or not. Any time you invest in bonds you need to consider what fluctuations in interest rates will do to your investment’s value.
If you’re reading this post and you don’t know whether your bonds are investment grade or not (yikes!), look up their ratings online now! As previously stated, bonds rated below BBB are junk bonds.
There are many risks involved with high yield bonds. Their increased risk levels are comparable to those of some stocks, which is something a lot of investors don’t realize. Be sure to consult with your investment advisor about the risks involved with any type of investment before making a decision to buy or sell. Check out this week’s podcast to learn more about high yield bonds.
You can learn even more about high yield bonds here: http://www.sec.gov/investor/alerts/ib_high-yield.pdf