To understand high yield bonds, let’s define what a bond is. A bond is an interest-bearing investment that obliges the borrower to pay a specific amount of interest for a specific period of time and then at maturity to repay the investor the original amount of the loan. High yield bonds are bonds issued by corporations. These companies pay interest rates higher than those of top quality government or corporate bonds to attract investors. Corporate assets back the bonds; in case of default, the bondholders have a legal claim on those assets.
High yield bonds can offer many advantages:
- As the name implies, high yield bonds frequently have higher yields. They can be called (redeemed) earlier, which is one reason investors receive higher interest payments. In general, these bonds have shorter maturities. Downturns in this investment category have not been as dramatic as in other investment categories.
- High yield bonds have become a large global market and lack of liquidity is not a huge concern.
- High yield bonds are not perfectly correlated with other investment categories.
- High yield bonds have to earn higher returns in order to compensate investors for higher risk. High yield bonds tend to combine the higher returns associated with equities and the lower risk associated with bonds.
- These bonds will fluctuate based on more than just the direction of interest rates; they will also increase or decrease in value as the issuing company improves its financial performance.
During the previous five years, high yield bonds have generated superior returns compared to more conservative bond funds. However, these returns are less than those of some aggressive equity funds. Investors should invest a portion of their portfolio in this investment category to reduce their risk and increase their income and return potential.
High yield bonds play an important role in a well-diversified mutual fund portfolio for both the conservative and aggressive investors. This sector will still incur risk, but the worst downside risk displayed by this investment category was a loss of 8 percent. Investors who want to capitalize on the opportunities of high yield bonds could consider several mutual funds.