High Yield Investments

Updated on April 19, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Are High Yield Investments?

High yield investments refer to those financial instruments that offer impressive returns to the investors but involve a great deal of credit risk. These are usually fixed income instruments issued by highly leveraged or small scale companies. The issuer attracts investors by offering a higher interest rate than safer investment-grade bonds in exchange for the increased risk.

High Yield Investments

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They have the potential to earn a higher return compared to traditional investment avenues like government bonds or savings accounts in banks. Factors like market fluctuations or unfavorable economic conditions or even the type or nature of the investment affect their risk level.

Key Takeaways

  • High-yield investments offer the potential for higher returns but also have higher risks than traditional investment options.
  • High-yield investments can encompass a range of financial products or strategies, including high-yield bonds, high-dividend stocks, peer-to-peer lending, REITs, certain alternative investments, or speculative ventures.
  • Investors considering high-yield investments should conduct thorough due diligence, carefully assess the associated risks, and diversify their portfolios to mitigate potential losses.
  • Investors need to evaluate their risk tolerance, investment objectives, time horizon, and overall investment portfolio before allocating a portion of funds to high-yield investments.

High Yield Investments Explained

Companies operating on a smaller scale, or in an emerging phase, highly leveraged companies or those under financial stress are often the ones that issue high yield corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more.

When an economy enters the phase of recession, investors seek a safe haven and thus move to better quality investments, with higher credit ratings and reliability. However, in case of interest rates being lowered or turned negative by the central bank, some investors tend to get attracted to high yield investments for better returns.

In addition to the economic conditions, the investor must be aware of several other factors (mentioned above) relating to the issuer, the bond features, and the market.

The risk-return trade-off in best high yield investments should be well understood prior to making an investment decision. High yield investments are better suited to investors with risk toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more, i.e., those who are willing as well as capable of taking on financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more.

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Factors

Some common factors that influence the high yield of investments are as follows:

  • Market conditions influence the yields to a great extent. Good economic conditions and low interest rates favour high yields.
  • The particular sector or the industry performance has an influence on it. A possibility of strong growth potential or good dividend offer good yields and they are high yield return investments.
  • Companies having a weak balance sheet with low credit rating can significantly impact the yield. They usually offer higher interest rates for compensating high risk of investing on their stocks.
  • The liquidity of the investment option is also a factor that influences investment. Some investment which has limited liquidity level and can be challenging to sell off, offers high yield as a compensation feature.

Credit Rating

Credit rating agenciesCredit Rating AgenciesCredit rating agencies (CRAs) evaluate and rate the creditworthiness of debt securities and their issuers, including companies and countries.read more conduct thorough credit analysisCredit AnalysisCredit analysis is the process of drawing conclusions about an entity's creditworthiness based on available data (both quantitative and qualitative) and making recommendations about perceived needs and risks. Credit analysis also involves identifying, assessing, and mitigating risks associated with an entity's failure to meet financial commitments.read more of bond issuers as well as the bonds. Based on the creditworthiness and default risk assessed, a credit rating is assigned on the following scales:

Rating and Grading

As per the rating scales used by S&P and Fitch Ratings, instruments with ratings between AAA and BBB- are considered investment grade, while those rated BB+ and below are of speculative-grade. On Moody’s scale, instruments with ratings between Aaa and Baa3 are of investment-grade, while those rated Ba1 and below are of speculative-grade.

Such ‘speculative’ or non-investment grade bonds are the ones that offer higher interest rates and are categorized as best high yield investments. These are also often referred to as Junk bonds due to their low quality.

Examples

Some examples of high yield investment opportunities are the following:

#1 – Growth stocks – Such stocks are of companies having a high growth potential, but they are also vulnerable to market fluctuations. Thus, they offer a high dividend yield with a high degree of risk.

#2 – Junk bonds – These category of bonds have a high risk of default from the issuer because they are issued by entities who are financially unstable. They offer higher yields to investors as a compensation for the default risk.

Advantages

Just as every concept has its own advantages and disadvantages, this concepts high yield investment opportunities also has the same. Let us look at the advantages first:

#1 – Higher Returns

As explained earlier, the high yield return investments gives the investor a chance to increase earnings. Thus, in spite of their quality and creditworthiness, high yield investments are widely held by investors, including mutual funds and Exchange-traded fundsExchange-traded FundsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange.read more worldwide.

#2 – Turnaround Opportunities

The issuer’s creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more may improve, leading to an upgrade in ratings and better future prospects. This could be through an improvement in the issuer’s record of repayments, business performance, cash flow managementCash Flow ManagementCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, etc. It is important to evaluate the future prospects and true value of investment and credit strength in such cases.

#3 – Other Benefits

General features of bonds also high yield bondsHigh Yield BondsHigh yield bonds are bonds that pay higher interest than others but are assigned lower credit ratings by popular credit rating agencies. Ratings below “BBB” from Standard & Poor and below “Baa” from Moody’s are due to additional credit risks involved in interest and principal repayment.read more, which are beneficial when compared to equity shares, such as priority of payments at the time of liquidation, lower volatility, more secure returns, etc.

High-Yield-Investments

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Disadvantages

Given below are some of the disadvantages of the concept.

#1 – Credit Risk

One of the key characteristics of high yield investments is the high level of credit risk involved. There is a probability that the issuer may default on some or all of the interest payments and principal repayment. These bonds may then even become worthless. Higher credit risk leads to the widening of the spread over the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more.

Investors should be cautious of the risks involved through in-depth research of the bond covenantsBond CovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements.read more, debt structure of the company, credit ratings (issuer’s as well as issues), company and industry fundamentals and condition, interest, and repayment history if any. Most of these details can be found in the prospectus of a bond offering. Metrics such as the probability of default, loss given defaultLoss Given DefaultLGD or Loss Given Default is a common parameter to calculate economic capital, regulatory capital, or expected loss. It is the net amount lost by a financial institution when a borrower fails to pay EMIs on loans and ultimately becomes a defaulter.read more, and the recovery rate also help investors and analysts gauge the risk in these investments.

#2 – Liquidity Risk

Investors may not be able to execute the sale of a high yield investment programs, like high yield bond in the market as easily and conveniently as the safer, liquid investments. The investor is at risk of not being able to fetch a fair price and, as a result, may incur a loss.

Transaction costs, lower volumes, and lower frequency of trading are some of the major factors contributing to liquidity risk.Liquidity Risk.Liquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more Liquidity risk makes investors hesitant at the time of investment and sale before maturity.

#3 – Sensitivity to Ratings

Also referred to as migration risk, the risk of a downgrade in credit ratings negatively impacts the market value of a bond. As compared to investment-grade bonds, high yield bonds or high yield investment programs are generally more sensitive to such changes.

#4 – Economic Conditions

In a weakening economy, investors tend to move to better quality investments, also referred to as ‘flight to quality.’ Although this would mean losing out on higher yields, it gives them a sense of security and lowers the probability and intensity of potential losses from risky investments.

This puts downward pressure on the high yield bond values as their sales increase. Also, issuers with a weak credit standing are more vulnerable to underperformance as they are less capable of sustaining their earnings and paying off debt in a recessionary phase.

#5 – Other Risks

The general, inherent risksInherent RisksInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more apply to high yield bonds as well. For example, the market price movements of a high yield bond are negatively related to interest rate movements. This creates an interest rate riskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more – where bond values fall in times of rising interest rates.

Frequently Asked Questions (FAQs)

1. How do high-yield investments differ from other types of investments?

High-yield investments, also known as speculative or junk bonds, offer higher yields but come with higher risks than other types of investments, such as government or investment-grade corporate bonds. The higher yields are offered to compensate investors for the increased risk associated with investing in companies with lower credit ratings.

2. How does market volatility affect high-yield investments?

Market volatility can have a significant impact on high-yield investments. During periods of market volatility, investors tend to become more risk-averse, leading to a decrease in demand for high-yield bonds. This can result in a decline in their market value and an increase in their yields. Conversely, when the market stabilizes, demand for high-yield bonds may increase, decreasing yields and potential capital appreciation.

3. Are high-yield investments suitable for conservative investors?

High-yield investments are generally considered more suitable for aggressive or income-seeking investors willing to take on higher levels of risk in exchange for potentially higher returns. Conversely, conservative investors, who prioritize capital preservation and have a lower risk tolerance, may prefer more stable and lower-risk investments. 

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This has been a guide to what are High Yield Investments. We explain its factors and credit rating along with examples, advantages & disadvantages. You can learn more about Risk Management from the following articles –

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