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Bonds are instruments of debt issued by companies and governments in exchange for a specified interest rate. Bond issuers are able to use bond revenues to expand their operations or pay off more expensive debt. The interest rates offered on bonds are affected by a number of market factors, but also depend on the creditworthiness of the company issuing them.
If a company is in a poor financial position, it will need to offer a relatively high rate of return on its bonds in order to compensate investors for taking on more risk. In fact, the bonds of particularly risky companies have been traditionally referred to as “junk” because they carry a high risk of default.
Advantages of High-Yield Bonds
There are a few reasons why high-yield bonds can be great investments:
Higher rate of income. The clearest benefit is a high rate of return. For some, this can be a great way to achieve higher returns in a fixed-income portfolio relative to other offerings.
Value of the bond itself may appreciate. If the underlying company’s credit rating improves, the value of the security may increase. Thus, if you are confident in the future of a specific company that you feel unfairly suffers from a negative credit rating, you may have identified an attractive investment.
Takes precedence over stock during liquidation. Many people feel that high-yield bonds should be avoided because if the company defaults, the bond becomes worthless. But what they fail to realize is that buying a high-yield bond is still safer than buying stock from the same company. If the company does default, all is not lost because bond holders are paid before stockholders in a bank liquidation. In other words, there is still a chance to recover something if the company does indeed go bankrupt.
Income can be more dependable than stocks. As long as a company doesn’t default, the income that any bond provides will be consistent.
High-yield bonds in a recession-resistant company may be underrated. Some industries actually thrive in a recession (such as discount retailers or gold miners). Such companies that are considered “risky,” however, may actually be no more risky than a highly-rated company that is in a recession-vulnerable industry.
Disadvantages of High-Yield Bonds
The following factors should be taken into consideration before committing to these investments:
High risk of default. High-yield bonds are issued when the likelihood of default is deemed higher than that for similar companies. Since a default means you could lose your entire investment, risk averse investors may want to avoid high-yield bonds.
Less liquid. Because of their stigma, many investors are reluctant to purchase high-yield bonds, which can make reselling them difficult.
Prices are affected by changes in credit rating. Just like an improved credit rating can boost bond prices, if a company’s credit deteriorates further, the price of their bonds can drastically decrease.
Prices are affected by interest rates. This point applies to all types of bonds, since they are all affected by changes in interest rates. If interest rates rise, existing bonds will become less valuable. Conversely, if interest rates decline, bond values typically increase.
Value may decline during a recession. During a recession, investors typically run to conservative investments like cash, gold, and investment-grade bonds. However, high-yield bonds may not experience the same rise in value because they’re already seen as risky and may become that much more risky when the economy heads south.