The attractive yields and diversification benefits come with plenty of risks
High-yield fixed income investments, also known as "junk bonds," are a type of debt security that offers a higher yield than investment-grade bonds due to their higher risk of default.
In a rising rate environment – where interest rates are increasing – these investments can offer investors attractive advantages but they also bring plenty of worrisome disadvantages too.
Advantages of Junk Bonds As Rates Rise
Higher Yield: In a rising rate environment, high-yield fixed income investments typically offer higher yields than other fixed income securities. This can be an attractive feature for income-seeking investors who want to earn a higher return on their investments.
Potential for Capital Appreciation: On the other hand, high-yield bonds can also offer potential capital appreciation if interest rates begin to fall again. This is because when interest rates fall, bond prices rise, which can provide investors with a capital gain on their investment.
Diversification: High-yield fixed income investments can provide diversification benefits to a portfolio. This is because they are typically not highly correlated with other asset classes, such as stocks and investment-grade bonds. This can help to mitigate overall portfolio risk and volatility.
Disadvantages as Rates Rise
Higher Default Risk: High-yield fixed income investments are considered riskier than investment-grade bonds, as they have a higher risk of default. In a rising rate environment, this risk can be amplified, as companies may struggle to make their debt payments when interest rates are higher.
Interest Rate Risk: High-yield bonds are also susceptible to interest rate risk, which is the risk that bond prices will fall as interest rates rise. This can be a significant risk in a rising rate environment, as investors may experience a decline in the value of their investment.
Liquidity Risk: High-yield fixed income investments can also be less liquid than other fixed income securities. This is because they are typically issued by smaller, less-established companies that may not have as much demand for their bonds. In a rising rate environment, this can make it difficult for investors to sell their bonds (at their desired price) if they need to raise cash quickly.
Your Financial Professional
High-yield fixed income investments may provide attractive yields and diversification benefits to your portfolio, but they also bring plenty of risks.
As such, investors should carefully consider their risk tolerance and investment goals before investing in these securities, especially in a rising rate environment.
Important Disclosures
Content in this material is for educational and general information only and not intended to provide specific advice or recommendations for any individual.
Investing involves risks including possible loss of principal.
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This article was prepared by FMeX.
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