Interest rates at historically low levels are great for those looking to refinance a mortgage or borrow money to start a business. However, people who rely on their investments for income have sought out a variety of alternatives to rock-bottom yields on U.S. Treasuries, including high-yield bonds. If you’re considering investing in high-yield bonds–sometimes called “junk bonds”–yield shouldn’t be the only factor in your decision.
What are high-yield bonds?
High-yield bonds are corporate bonds considered less than investment grade (a rating of BB or lower from Standard & Poor’s or Fitch, Ba or lower from Moody’s). A bond can fail to achieve investment-grade status for many reasons. A company may be in a turnaround situation; high-yield bonds have frequently been used as a way to finance large-scale leveraged buyouts, such as that of RJR Nabisco in the 1980s. Or the company might already have substantial debt on the books, or have a risky or untested business model. Whatever the reason, there is greater uncertainty about the company’s ability to repay its debt.
So why would an investor be willing to face those risks? In a word, yield. The more uncertainty about an issuer’s ability to repay its debt, the higher the interest rate investors typically demand from its bonds. As of early November 2012, one benchmark index of high-yield bonds was yielding almost 4% more than a comparable index of corporate bonds, and almost 5% more than a 10-year Treasury.*
Because a junk bond’s yield is often more dependent on the quality of the issuer than on other factors, it can sometimes be less affected by interest rate changes than investment-grade yields. That difference can provide an additional level of diversification for a bond portfolio (though diversification alone cannot guarantee a profit or protect against potential loss). You can provide still another level of diversification by investing in a variety of high-yield bonds from different issuers in different industries.
Don’t forget that even high-yield bonds typically have precedence over common stocks in the event of a bankruptcy; that increases the odds that you would receive at least part of your original investment if the issuer went under.
Factors to consider
Not surprisingly, default rates on high-yield bonds tend to be lower when the economy is robust; renewed recession could mean more defaults by companies already on shaky ground. Also, remember that selling any bond before it matures could mean a loss of principal. While interest rates are expected to remain low for another couple of years, bond values generally are likely to fall when rates begin to rise. A credit rating downgrade of your high-yield bond also would likely reduce its market value. Finally, recent investor interest has boosted prices of high-yield bonds generally; consider getting expert help in deciding whether high-yield, investment-grade debt, or dividend-paying equities represent a better investment at current valuations.
If you’re a long-term investor, there’s another factor to consider. Bonds can have a call provision that lets the issuer redeem the bond before it matures. The lower current interest rates are, the more likely they are to trigger call provisions on bonds with a higher rate. If you rely on the interest from a high-yield bond and it gets called, you’ll be faced with the challenge of replacing that income.
Also, individual high-yield bonds can sometimes be less liquid than investment-grade bonds, so you might have some difficulty selling the bond at your asking price. And during periods of global uncertainty, high-yield bond values can drop as investors flock to less risky investments generally. As with any investment, make sure you’re being compensated for the level of risk you’re willing to take.
*Data based on yields reported for Merrill Lynch High Yield Constrained Index, Barclays Capital U.S. Corporate Bond Index, and daily Treasury yield curve rates as of November 7, 2012.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013