What are High Yield Investments?
High yield investments are mainly fixed-income instruments that carry higher risk and return (yield). The issuer attracts investors by offering a higher interest rate than safer, investment-grade bonds, as a reward for the higher risk involved.
Credit Rating of High Yield Investments
Credit rating agencies conduct thorough credit analysis 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 funds 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 management, 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 bonds which are beneficial when compared to equity shares, such as priority of payments at the time of liquidation, lower volatility, more secure returns, etc.
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 widening of the spread over the risk-free rate.
Investors should be cautious of the risks involved through in-depth research of the bond covenants, debt structure of the company, credit ratings (issuer’s as well as issue’s), 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 default, 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 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 risks 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 risk – where bond values fall in times of rising interest rates.
Conclusion/Key Takeaways
- High yield investments, as opposed to investment-grade, involve higher credit (default) risk and offer a higher rate of interest to attract investors
- 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 bonds.
- 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 a risk tolerance i.e. those who are willing as well as capable of taking on financial risk.
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