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.
Understanding High Yield Investments
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 high yield bonds 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.
Credit Rating of High Yield Investments
Credit rating agencies 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:
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 that 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 high yield investments. These are also often referred to as Junk bonds due to their low quality.
Advantages
#1 – Higher Returns
As explained earlier, the higher rate of return from these 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 creditworthiness 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.
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Disadvantages
#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 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 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.
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