People who have extra cash to invest are in a real dilemma these days: stock prices are hovering around all-time highs and bond yields are near the lowest point in perhaps a century. But, like anything, buying near the top of the market can result in undue portfolio risks. But, this also provides a great sales opportunity for securities brokers to pitch “High-Yield” Bonds.
If high-yields sound too good to be true, they truly are. Sure, a high-yielding investment with the apparent stability of bonds can be appealing in today’s financial markets. But, there is a reason why these securities, also known as “Junk Bonds” are, in fact, just too good to be true. If your broker recommends them to you, ask why the yield is so high. You see, high-yield means high-risk! That’s the point which is generally omitted.
Here’s a quick explanation of how bonds are traded. Corporations generally have two types of capital: Debt and Equity. Investors buy bonds of a corporation for stability, since they are “guaranteed” to receive their initial investment (the “par value”) on the maturity date, plus regular interest along the way. And Equity is raised when a company sells shares in the stock market. Stockholders assume the investment risk, since they have no guaranteed return of principal. The share price, however—and the value of their investment—will grow if the company succeeds.
Bonds have twelve ratings—from AAA, AA, A, BBB, and so on. Those in the top four credit ratings are referred to as “Investment Grade”. As bonds decline in quality, the potential risk of a loss of the bondholders’ principal increases. Accordingly, when the rating declines, the bonds are considered to gradually assume, more and more of the characteristics of stock. Additionally, bond yields increase as the credit rating declines, thus compensating the investor for the additional risk.
As global financial markets have soared recently, there has also been a “Flight to Quality”—money shifting to high-quality bonds and stock industrial sectors, such as: consumer staples (cecessities), energy and utilities, which are more risk-averse. This means that investing in High-Yield Bonds—Junk really—is a move in the opposite direction as to where investment dollars are currently going. Don’t fight the Market!
NOTE: For simplicity, I did not go into detail about bonds, such as trading losses and corporate bankruptcy. Prior blog posts, several years ago, went into such detail. To read those posts, just search for “Bonds” in the upper right-hand corner. Or leave a comment for anything that you cannot find an answer to.