Before You Say Hi to High-Yield Bonds, Read This

By Alert Investor Markets Fool.com

Risk and reward. Just like peanut butter and jelly, these two things often go together.

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The level of risk associated with a particular investment generallycorrelateswith the level of return the investment might achieve. Generally, that's because investors willing to take on additional risk demand to be compensated accordingly.

In corporate America, companies are rated based on their credit quality -- that is, the likelihood that they will be able to repay their debt based on factors such as their financial situation, business prospects, and past repayment history. If a company is deemed by credit rating agencies to have a generally low risk of default, then it will receive a good credit rating and be considered "investment-grade."

If a company, however, is deemed to have a high risk of default, then it may be rated low enough to be considered non-investment-grade. If such companieswant to issue bondsto raise money, they'll have to offer higher interest rates to attract investors. The types of bonds they would issue are called high-yield bonds.

As with other types of bonds, when you buy a high-yield bond, you arelending money to the issuer. In exchange, that issuer promises to pay you interest, also known as a coupon. The issuer agrees to pay you back your principal -- the bond's face value -- when the bond reaches its maturity date.

"A high-yield bond would have a higher coupon rate to compensate the investor for that higher risk of default," said Cara Esser, a senior analyst covering fixed income at Morningstar.

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Today, somewell-known companiesand many lesser-known companies issue high-yield bonds, sometimes referred to as "junk bonds."

Investors seeking greater returns than what they might get from a Treasury bond or an investment-grade corporate bond might look to high-yield bonds instead. But that doesn't mean they're right for you.

"These bonds need to be used with a lot of caution," Esser said.

Read on to learn more.

Image source: Getty Images.

How do you know a bond is considered high-yield?

Like students who get report cards, bonds get ratings from ratings agencies. Bonds ratedbelow Baa3by ratings agency Moody's, or below BBB by Standard & Poor's and Fitch Ratings, are considered "speculative grade" or high-yield.

How do you invest in high-yield corporate bonds?

Investors can buy individual high-yield bonds. Alternatively, they can invest in a basket of high-yield bonds by purchasing shares in a high-yield mutual fund or a high-yield exchange-traded fund (ETF).

With the latter two, you are spreading your risk among a basket of high-yield bonds, and you have a professional investment manager assessing the credit-worthiness of the bonds in the funds.

But high-yield mutual funds and ETFs also come withrisks. For instance, if a number of investors wanted to cash out their shares, the fund might have to sell assets to raise money for redemptions. The fund might have to sell bonds at a loss, causing its price to fall.

What some of the key risks of investing in high-yield bonds?

There are many. Here are some to consider.

  • Default risk: There's a risk with any bond that the issuing company might not be able to meet its obligations. The risks are higher with high-yield bonds.

  • Interest rate risk: Generally speaking, bond prices move in the opposite direction of interest rates. When interest rates go up, bond prices tend to go down. Longer-maturity bonds are especially vulnerable because there is a longer period during which interest rates might change.

    However, high-yield bonds are generallyless affectedby interest rate moves than other types of bonds because they generally have shorter maturities and pay out higher interest.

  • Economic risk: When the economy gets shaky, investors might rush to shed their high-yield bonds andreplace themwith safer ones, such as U.S. Treasury bonds.It's important to understand that high-yield bonds tend to move in the same direction as stocks. Therefore, if an investor is looking diversify a stock-heavy portfolio, he are she might not achieve that objective with high-yield bonds.

    High-yield bonds are "equity-esque," said Tom Roseen, the head of research services at Thomson Reuters Lipper. "Generally when the economy is doing well and stocks are doing well, high-yield does well."

  • Liquidity risk: Liquidity is the ease of selling an investment. High-yield bonds can sometimes beless liquidthan investment-grade bonds.

  • Downgrade risk: It's possible that a credit rating agency might lower its rating on a bond issuer. A downgrade could hurt the price of the bond.

  • Company or industry risk: There may be any number of reasons why a company would not be able to meet its obligations. Management might be doing a poor job, or there might be unforeseen industry headwinds. Such issues could add to a high-yield bond's risk.

What should you do if you are considering investing in high-yield bonds?

Do your research. For instance, useful information can be found in the prospectuses filed by companies offering high-yield bonds.

Prospectuses for registered corporate bond offerings can be found on the SEC'sEDGARwebsite.

Keep in mind the basic principle of risk and reward. A high-yield bond might appear enticing because of its high interest rate. But the reward you might potentially receive may not be worth the risk involved.

An Alert Investor is a smarter investor.

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