Oct 19, 2012

High Yield Bonds Prove to be a Risky Way to Drive Investments

Return on investments is the most important aspect attracting investors to select any financial instrument. The potential risks attached to high yield bonds are overlooked by most in lieu of the great returns they offer. But a number of risks must be gauged to mitigate risk in the portfolio.


Bonds have their own Moods, according to Moody’s rating agency

Debt obligations having bond rating BA or BB according to rating agencies Moody’s or Standard & Poor’s scale is known as High Yield Bonds. Also, known as junk bonds or below investment grade, the Bonds can be taken by investors either through individual issues or high-yield mutual fund investments.

Credit Risk: the Key Driver of High Yield performance

One of the primary concerns is the credit risks associated with high yield bonds. This means there is a possibility of the issuer defaulting in interest or principal payments.  One should carefully scrutinize the track record of the fund by going through various annual and semiannual reports. The bond price can drop in case of defaults which may result in the decline of the net asset value of the fund.

Economic Risk: Slower Growth Can Hurt High Yield

High yield bonds are issued by unproven and smaller corporations or else bigger companies having experience of handling financial distress. A slow economic growth can hamper the bond yield.

Investor Sentiment: A Key Issue

These bonds are sensitive and react sharply by under performing more than other kinds of bonds if investor sentiment becomes negative.

Nothing is stable: Ratings can change

Unfortunately, a bad year may lead to downgrading below the investment grade. Even though they have produced better returns than corporate issues as well as government bonds, high volatility and the risk of default must be considered by investors.

Even though Fitch Ratings have assessed that default rates are at historic low of 2.5 to 3 % recently.

Go Retro: read past records

One should assess the fund’s performance during previous downturns. The fund’s average credit quality can be an indicator to show if most of the bonds are below ‘B’ or ‘BB’, then it is highly speculative.

With more and more economies falling into recession and getting trapped in the trap of rising interest rates, the bond yields can greatly suffer. Also, do remember the fundamental relationship between interest rates and bond prices, i.e. bond prices go down with increase in interest rates.

Also, the yield of these bonds during a bull market run may be mediocre vis-à-vis other financial investments like equity return.

The sluggishness in the Bond market may make fund managers buy and sell from the existing portfolio, which may ultimately result in investors bearing additional costs. Other risks like changes in currency rates, weakening foreign economies and various political risks may result in nose-diving of high yield bond yields. 

So, is it really worth the pain?

A lot of analysts raise concern that whether high yield bonds which earn about 7 % are worth the kind of risk they are associated with.

This is because investors these days have multiple options of investments which provide better returns and the risk quotient is almost the same.

Lauren Devaney is the author of this post. She provides tips on smooth cash flow and investment strategies. For more information, visit www.paydayloansuk.org.uk

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