Understanding risk/reward trade-off
Like stocks, bonds come in many flavors to satisfy different investment appetites. Those that pay the highest interest rates are generally called high-yield bonds.
Their name tells one side of the story: They pay high rates of interest because they have lower credit ratings. In other words, they generally pay more interest to compensate for the higher risk investors take when they buy them.
How ratings are set
Credit rating agencies, such as Standard & Poor’s Rating Services and Moody’s Investors Service, evaluate bond issuing companies and organizations based on their ability to pay interest and repay principal as scheduled. Issuers that appear to be at greater risk of default - not paying interest and principal on time - are rated below investment grade. They receive ratings of Ba or below from Moody’s Investors Service or BB or below from Standard & Poor’s Rating Services. On the other hand, US Treasury and other bonds considered to have a low risk of default are "investment grade." They are rated Baa or higher by Moody’s or BBB or higher by Standard & Poor’s Rating Services. One important point: Defaults may not be the reason that shares of a high-yield bond fund decline in value. The decline may be due to market price fluctuations.
What’s the attraction?
Why might an investor be willing to take on higher risk? High-yield bonds may provide higher yields for income-oriented investors. In addition, because high-yield issues tend to be less interest-rate sensitive than other bonds and their performance doesn’t necessarily correlate to the stock market, they may help diversify an investment portfolio. If one investment decreases in value, others may increase in value, possibly helping to offset losses.
As with many investments, the best way to add high-yield bonds to a portfolio may be through mutual funds. High-yield bonds generally need to be carefully analyzed by a professional, such as a mutual fund manager, who has the experience to identify high-yield bonds that may be worth the risk they involve. The manager of a high-yield bond fund uses a number of approaches to manage risk. These include analyzing credit quality, assembling a diversified mix of bonds, and studying industry and economic developments that could affect the performance of the portfolio.
If the income and diversification potential of high yield bonds sounds attractive to you, be sure to talk with your financial advisor. Together you can determine whether you have the risk tolerance and time horizon that these investments require.
High-yield bonds are subject to greater risk of loss of principal and interest than higher-rated investment grade bonds. Purchasers should carefully assess the risks associated with an investment in a high-yield bond fund.
