When interest rates are low, high bond yields can be very attractive. But investing in high-yield bonds is not for unsophisticated investors. This is an arena best left to investors who are able to interpret the financial statements of publicly traded corporations in order to determine which companies are likely to continue paying a high yield on their bonds and which companies might be headed down the slippery slope to bankruptcy.
Moody's and Standard & Poor's are considered to be the best-known bond rating agencies. They rate bonds according to the financial strength of the companies that issue them. Bond ratings of AAA, AA, A and BBB are considered to be the highest investment-grade quality. Bonds with ratings below BBB are considered high-yield bonds -- or junk bonds -- and are very speculative. Companies issuing high-yield bonds have a greater likelihood of defaulting on their interest and principal payments.
When yields on investment-grade bonds are hovering around 2 percent or 3 percent, high-yield bonds can often pay investors 10 percent or more. Also, the value of bonds paying a high yield can increase if the company issuing the bond reports improved earnings or it acquires or merges with another highly profitable company. High-yield bonds perform best when the economy is growing and interest rates are stable or declining. But even if a company issuing high-yield bonds goes belly up, bondholders are first in line ahead of stockholders and others creditors to receive what is left of the company's liquidated assets.
There is always the chance that a company issuing a high-yield bond could fall on hard times and the value of its bonds could tank. If that happens, investors could lose a chunk of their initial investment, which is not a good scenario for usually conservative bond owners. Investors who buy high-yield bonds also face the risk that during dramatic sell-offs in the high-yield bond market there may not be any buyers for their bonds.
Diversification high-yield bond purchase is often recommended as a way to lower your risk. If you don't have enough money to buy high-yield bonds from many different companies, you may invest in a high-yield bond mutual fund to achieve the diversification you need. Limiting the amount of money you invest in high-yield bonds to a small percentage of your investment portfolio may help you avoid the potential for heavy losses.
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