High-Yield Bonds: Double-Digit Returns & Key Risks Explained

Are you looking at high-yield bonds for their attractive returns? While they are currently advertised with double-digit returns up to 14 percent, it’s crucial to understand the significant risks involved before you consider investing.

These bonds typically carry ratings from AA- to BBB and are often issued by newer companies in growth phases that may not qualify for higher credit ratings.

Key Numbers to Note

• Returns: Up to 14 percent currently advertised.
• Rating Range: Typically AA- to BBB.
• Diversification Target: 20-25 bonds across 5-7 sectors.
• Exposure Limit: Around 15-20 percent of your fixed-income allocation.

What Are the Risks You’ll Face?

The biggest risk you face with high-yield bonds is default, meaning the issuer might not pay you your coupon payments or even your principal back. This probability goes up for lower-rated bonds, especially if economic conditions worsen.

A credit rating downgrade can also directly hurt your bond’s market value, potentially making it worth less than what you paid. Then there’s liquidity risk; these bonds are less liquid than government securities, so you might have to sell at an unfavorable price if you need your money back quickly.

How Can You Manage These Risks?

One way to mitigate liquidity risk is to plan on holding the bond until its maturity. This can help you avoid mark-to-market fluctuations from selling early. Another strategy you can use is called laddering, where you invest in bonds with different maturity dates.

Diversification is also incredibly important for these portfolios. Ideally, you’d want to hold 20-25 bonds spread across five to seven different sectors to lessen the impact if one issuer defaults.

Who Are These Bonds For?

High-yield bonds are generally more suitable for investors who have a higher risk appetite and truly understand credit risk, including what collateral backs the bond and the issuer’s financial health.

If you’re a retiree, a conservative investor, or someone whose main goal is to preserve capital, these bonds might not be the right fit for you. Also, if you already have a lot of equity exposure, you might not need more high-yield credit risk.

Consider a Managed Approach

For most retail investors, managing a direct portfolio of high-yield bonds can be challenging due to the capital needed, the analytical skills required, and limited access to secondary markets.

A more practical approach for you might be a professionally managed route, such as a credit risk fund. These funds offer expert credit assessment and better diversification, taking some of the heavy lifting off your shoulders.