The Risk and Benefits of Investing in High Yield Bonds
All investments involve a certain degree of potential risks. Any financial investment requires research to ascertain the potential rewards along with the possibility of potential losses. High yield bonds offer a significant return at the end of the maturity period. However, the stability of the entity offering the bonds must be thoroughly evaluated.
High yield bonds offer an investor an opportunity to loan money to an entity through the purchase of the bond. The purchased bonds will have a specified maturity date with specific terms for the payment of the interest. The entity agrees to pay interest on the face value of the bond and the total is payable once the maturity date is reached. While this appears to be very basic and risk free, it is not.
Organizations are subject to credit ratings, which are issued by such credit rating companies as Standard & Poor’s. The organizations or entities that offer high yield bonds do not qualify for an investment grade rating. This means they have been evaluated on their ability to pay the loan and have not earned a favorable rating. Based on the evaluation, the rating earned does not meet the required standard of a sufficient investment grade rating. To the investor, this translates in a higher degree of risk, since the entity may default on the loan. To obtain sufficient financing, these organizations must offer a higher interest rate to entice the investor to purchase bonds that carry a high risk of possible losses.
The benefit to high yield investments, particularly bonds, is the potential of a significant return. If the entity experiences an upgrade in its credit rating or any type of positive financial event the capital appreciation potential will increase. Should the entity file bankruptcy or liquidation of assets, bond holders have priority over stockholders in recouping some of their investment dollars.
The disadvantage of high yield bonds is the lack of credit worthiness of the entity. The entity may have a high potential of defaulting on the agreed interest payments or the principal amount of the loan. The entity may experience a downturn in their market base and may not meet its financial obligations. If the entity’s performance declines their credit rating may be downgraded even further which may cause the bond price to decline. Many factors affect high yield bonds especially if an organization is on volatile financial ground to begin with.
Investing in high yield bonds will add diversity to your investment portfolio and certainly have the potential of a favorable return. It is essential to obtain pertinent financial data and credit ratings on the entity selling the bonds. Depending on the nature of the business, you must also consider if the business sector has the potential for growth during the current economic climate. If you were unsure of making such an investment, it would be prudent to seek professional advice from your financial adviser.
High yield investments certainly offer an opportunity for significant returns and a potential asset to your current portfolio.