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.
Benefits of High-Yield Bonds
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.
High-Yield Bond Risk
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.
Diversifying Your Portfolio
A 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.
Tim Grant has been a journalist since 1989 and has worked for several daily newspapers, including the Charleston "Post & Courier," the "Savannah News-Press," the "Spartanburg Herald-Journal," the "St. Petersburg Times" and the "Pittsburgh Post-Gazette." He has covered a variety of subjects and beats, including crime, government, education, religion and business. He graduated from The Citadel with a Bachelor of Science in business administration.