One commonly used indicator of risk when investors are choosing which bonds to buy is the credit rating.

Three major credit rating agencies – S&P, Fitch, and Moody’s – use a standardised set of rules to assign each bond a rating that indicates how likely you are to get your initial investment and returns in full and on time.

Bonds with a credit rating from AAA to BB are called investment-grade bonds. These bonds are at the lower-risk end of the spectrum.

At the other end are bonds rated BB to D which are called high-yield bonds (or junk bonds). These bonds give a better rate of return and the trade-off for this is that they are also riskier.

Here’s what you need to know about the risks and rewards of the bonds before you invest money.

Junk bonds

Although high-yield bonds may seem off-putting due to their lower credit rating, they have a lot to offer.

There is also a market for buyers and sellers in this category; in fact, some of the biggest, well-established Fortune 500 companies have in the past and continue to issue junk-grade bonds.

In a low-interest-rate environment, there are very few lucrative options for our money – money in a savings account or investment-grade bonds will generate very little return.

In addition, lending to businesses will typically be in smaller volumes in a low-interest-rate environment. This means businesses’ profits will not be as good and if you invest in equities, your returns may not be high either.

In these conditions, junk bonds may be appealing as they offer a high rate of return when almost no other investment does.

Given the opportunity, some investors, investing in Fortune 500 companies with a high rate of return seems like a clear choice for their money. However, the majority of investors still hesitate and are wary of junk bond risks.

Beware of junk bonds

This is most likely because of the historical price behaviour of junk bonds. Junk bond prices can be very volatile, meaning the price can swing up and down a lot.

Some investors find this kind of price behaviour unpleasant; one day you’re making lots of money on your investment, the next you’ve lost all of it.

The other concern is that some companies issue junk bonds but are not committed to returning initial investments from the outset. This is called market abuse.

You might buy a junk bond and that company may have already decided in advance that they would use your investment and declare bankruptcy before it is time to return your initial investment. You could lose all of your money with a higher probability with high yield bonds.

Many Wall Street professionals will argue that the negative outlook on high-yield bonds persists because of market abuse and questionable practices of financial and business professionals.

So, why invest in high-yield bonds?

In some cases, junk bonds do not necessarily deserve their negative reputation.

In fact, adding high-yield bonds to a mixed portfolio may reduce total portfolio risk. This is through the benefits of diversification, meaning all your eggs are not in one basket.

The returns on high-yield bonds do not move exactly in line with either investment-grade bonds or stocks – we say they are not strongly “correlated”.

This low correlation means adding high-yield bonds to a portfolio can be a good way to reduce risk and boost returns. Another benefit is that because the yields on junk bonds are higher than the investment-grade ones, they are not as vulnerable to interest rate shifts.

Also, if you are seeking a higher yield for your fixed-income portfolio, high-yield bonds can be a sensible choice as they have typically produced better returns than government bonds and highly rated corporate bond issues.

There are genuine situations in which good companies experience some phases of financial difficulty – a one-off bad year for profits can lead to a company’s bond ratings being downgraded to a level lower than investment grade.

In this situation, high-yield bonds can be a good opportunity for investment.

Emerging markets

Another option investors have when looking for high yield investments in a low-interest-rate environment is emerging markets, which currently account for a big portion of high-yield markets on a global scale.

Investing in emerging markets stocks and bonds is cheaper than when looking at developed nation’s securities. This is because you are exposed to a much smaller market.

Although emerging markets can appear to offer high rates of return on your money, this comes with a higher risk to your money as it can expose you to a wide range of unexpected risks.

Corruption, instability, poor infrastructure and many more conditions of doing business in emerging market regions lead to risk trickling through the economy and the banking and financial sector, which can impact your investments negatively.

This article first appeared in The New Savvy.

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