This is a guest post written by Gary Dek, a personal finance blogger and freelance writer at Gajizmo.com. Gary graduated from a top-ranked university with a finance degree and worked in the industry for 3 years before venturing out to work online.
When it comes to bonds, one man's “junk” is another man's high yield investment. High yield bonds offer a better coupon rate than other types of investments because they carry a higher risk of loss. Sometimes the risk to return is better for junk bonds than it is for stocks, though the S&P just returned 16% in 2012. Despite the higher risks, junk bonds are not necessarily a bad investment, especially for smart investors who calculate risk-adjusted returns based on the sustainability of the underlying assets and their respective cash flows. Nonetheless, junk bonds are high yield securities that can be an important part of an investment portfolio, but investors should consider their needs and goals before jumping into this market. As with any investment, there are advantages and disadvantages that need to be considered.
What Are High Yield Bonds?
Companies issue bonds as a way to raise money, making them, in essence, a type of business loan. The company may need the money to expand operations through capital expenditures such as property, plant and equipment, pay off higher interest debt, or share buybacks. Most companies issue bonds at one time or another, but high yield bonds are issued by companies that have a less than stellar credit rating. The rate of return on these bonds is dependent on the credit worthiness of the issuing company. Because companies in a poor financial position have difficulty attracting investors, they offer higher returns to compensate investors for the higher risk of loss. Higher returns also attract investors who are in a position to take a loss if the company folds.
Advantages of “Junk” Bonds
Junk bonds offer a higher rate of income than their more secure counterparts, which is the clearest advantage for high yield investments. In a diversified, fixed income portfolio, junk bonds are a way to achieve higher returns when compared to other safe investment options available. The value of the bond may increase if the issuer's credit rating improves. Investors who believe a company has an unfair credit rating may have identified an excellent investment.
Bonds are more secure than common equity shareholders if a company goes bankrupt because they take precedence during a bank liquidation of assets. While bondholders may take a loss, they usually recover at least some of their initial investment even if company stock is rendered worthless. While you may not make any money, you will probably not lose all of your investment either. Another advantage of bonds over stocks is that they provide a consistent income as long as the company does not default and continues to pay the coupon rate. The returns on stocks tend to fluctuate with the market.
Some businesses, like discount retail chains, are less vulnerable to recession than other businesses. High yield bonds in a recession resistant company may actually be just as secure as a long term investment in a highly rated company in an industry that is vulnerable to recession. Sometimes, recessions are not the only catalysts for a strong company losing its leadership in an industry. For example, BlackBerry (formerly Research in Motion) was well-known as the leader in business smart phones in the early 2000s. However, their complacence and lack of innovation left an enormous niche in the consumer market unfulfilled, and Apple jumped at the opportunity with an amazing iPhone product. Now, Blackberry is trying to stay alive with a new mobile operating system, but who knows if it will be enough? If Blackberry were not a technology company with no debt, and instead was a highly-levered manufacturing company left behind, chances are, their debt would have been downgraded.
Disadvantages of High Yield Bonds
As with any high yield investment, the risk inherent in junk bonds is higher than the risk of other investments. Investors who are adverse to risk, or who cannot afford to take a loss should consider the pros and cons of more secure investments like mutual funds or annuities. Since these bonds can be more difficult to sell than other securities, liquidity can be a problem. Investors who want to recoup their investment quickly should probably find financial instruments that can be sold easily.
The value of the bond will fluctuate with the company's credit rating. If the credit rating goes up, the value of the bond increases, but if it goes down, the bond may be worth less than the original purchase price. Like all other types of bonds, the prices are also affected by changes in interest rates. If interest rates go down, the value of bonds increase; but if interest rates go up, bonds decrease in value.
Additionally, junk bonds are subject to loss of value in a recession when investors run to conservative investments like gold and cash and investment-grade bonds. Since high yield bonds are viewed as risky even in a strong economy, investors believe they are even riskier during periods of recession.
Investing in Junk Bonds
The most common and probably the easiest way to buy high yield bonds is through a broker. Both online discount brokers and those with local offices can help you purchase bonds and some will even offer advice on the bonds that are best for your particular needs and goals. You should check to make sure the broker you use has a good reputation and charges a fair commission.
Another option is mutual funds that specialize in high yield bonds. Many mutual fund companies buy a variety of bonds (diversification) which offers more security than buying bonds from a single company. Check out the fund's performance and the types of investments they make before deciding where to put your money. Mutual funds may have a fee (load) at the time of purchase, and usually have annual fees for administering accounts.
The third way to invest in high yield bonds is to buy them directly from the company and not pay any sales commission. Commercial banks sometimes sell bonds with no commission, but this service is usually reserved for customers with large accounts.
Bond Prices Can Be Affected By Sales
Major purchases of bonds can affect their price and therefore their value, so small investors should know who invests in high yield bonds. Pension funds often invest in high yield bonds to increase their earnings, but they usually only invest a small amount of their total assets because government regulations prohibit high risk portfolios. Insurance companies are probably the largest investors in high yield bonds, which they use to fund annuities and other financial products they sell. While mutual funds invest in high yield bonds to an extent, they tend to be more conservative in their investments and limit their exposure.
For investors with a tolerance for risk, high yield bonds offer many advantages. It is important to do your homework and only place a portion of you total investments in these high-risk investments. While returns are high, high yield bonds will not necessarily behave like investment bonds and increase in value. The performance of these securities is affected by factors other than the company's rating, like interest rates and general economic environment. Unless you are 100% certain and comfortable with your investment choice, investors should always wait until allocating a portion of their portfolio to riskier alternatives. In the meantime, retail investors can always take advantage of short term investment options that offer greater returns than a checking or savings account. This way, your money is readily available for when you want to take the plunge, but is also yielding more than .01% interest.