Of all investment asset classes, equities (stocks) and fixed income (bonds) are the most common people invest in. And for good reason: Historically, they have helped investors create the greatest amount of wealth in the shortest period of time. However, when we talk about bonds, high-yield bonds are often left out of the discussion.
What to know about high-yield bonds
High-yield bonds have a nickname that scares people away: junk bonds. They are not junk! They are issued by companies with lower credit ratings and therefore tend to have more risk than investment-grade corporate bonds and Treasuries. The higher risk is due to the doubtability or durability of the cash flows to repay these bonds. In other words, they have a high default risk. But if they don’t default, the investor can make a fortune.
So essentially, high-yield bonds are a hybrid of stocks and bonds. Their yields are higher by 5% or more compared to corporate bonds, but they can be lower if the economy is strong. Why is that? Well, think intuitively here. If the economy is strong so is the business environment. Strong revenue will support strong cash flow, making it more likely that bond yields will be paid.
If the economy weakens, the inherent risk of bankruptcy or default increases; they are usually the first bonds that investors choose to sell. An investor who holds high-yield bonds may lose their entire investment.
High-yield bonds often move in tandem with the stock market. They are as risky as equities, but they can produce tremendous returns for the amount of risk taken. When investing in these bonds, know your risk tolerance!
The current market is bullish for equities and high-yield bonds. The yield spreads between bonds of different risk levels is tight, which indicates good demand for all levels of fixed income. But – that could change quickly.
