How High-Yield Bonds Can Help in Diversification
Updated on 17 Feb 2020
With their high interest rates, high-yield bonds or ‘junk bonds’ can easily better your portfolio. Diversification is just one of their advantages.
An investor is always faced with discretion to add the relevant type and category of bonds to his portfolio. All the investors that look towards safer options for investing their money can put fixed-income instruments into the driver’s seat. Any individual investor will look for the preservation of capital with a guaranteed income for future benefits in the market.
Today, investors need to mix things up and get exposure to different types of investments. This assists them in keeping their portfolio incomes high, and at the same time, reduce risks. It will also help them to prevent their investment against the impact of any kind of market inflation.
A good portfolio consists of investment products that include a range of bonds with different maturities. This helps to secure your principal amount from changing market interest rates. Bonds show real returns of somewhere around 3%, even after inflation considerations.
What is portfolio diversification?
In the fields of finance and investment planning, portfolio diversification is the strategy of risk management by combining a variety of assets to reduce the overall risk of an investment portfolio.
Diversification means not investing everything the investor has in one area. For example, if an investor puts all his money in one stock, or all in equities, or real estate, his portfolio is not considered diversified.
What are high-yield bonds?
A high-yield bond is a bond that pays good returns. It has a lower credit rating than investment-grade bonds like corporate bonds, Treasury bonds, and municipal bonds. These bonds have a higher risk of default, but at the same time, these bonds pay a higher yield than investment-grade bonds.
These bonds are also popular in the market as ‘Junk Bonds’.
All bonds are rated by the two main credit rating agencies like Standard and Poor and Moody’s. The high-yield bonds carry a rating below “BBB” from S&P, and below “Baa” from Moody’s. Bonds with ratings above these levels or at these are considered Investment- Grade bonds.
How can high-yield bonds diversify your portfolio?
High-yield or junk bonds fall under a seemingly unstable category of investments. However, a bond classification below-investment-grade does not necessarily mean that a company is mismanaged or it is engaged in fraudulent practices. Many financially sound firms run into financial difficulties at various stages.
However, with lower credit ratings, these firms are considered less creditworthy. This means that borrowing money is more expensive for these companies. They have to pay more interest on their debt, just like individuals with low credit scores often pay a higher rate on their credit cards. Therefore, they are called high-yield bonds as they offer higher interest rates because of the additional risks. These risks can be either default risks or interest rate risks as per changing market conditions.
What are the advantages of including high-yield bonds in your portfolio?
A sound investment portfolio should consist of an equitable distribution of assets and stocks for better returns and opportunities. If you are interested in investing in bonds, you can have a fair distribution of long-term and low risk and short-term or high-risk bonds. High-yield bonds can also have a safe place in the investor’s portfolio if you exercise a little bit of discernment and intelligence.
The high-yield bonds can provide the investor with these advantages or benefits:
- Greater returns – High-yield investments generally produce better returns than investment-grade bonds as a result of the increased interest rates. High-yield bonds also have higher returns government bonds in the long run. This is especially beneficial if you are looking to get a higher yield within your fixed-income portfolio. High-yield bonds are the best source of income.
- Protection from bankruptcy or defaulting – Debt securities, like bonds, have an advantage over equity investments if a company goes bankrupt or gets into default. Whenever such a scenario of default arises, bondholders would be paid first during the liquidation process. Then the privileged stockholders are paid, and lastly, the common stockholders are paid. This acts as a kind of safety feature that can protect your portfolio from significant losses. It can also help to reduce the damage from defaults.
- Provide a classic case of diversification – The yields from High yield bonds are higher than investment-grade bonds. Therefore, they are less prone to interest rate fluctuations. This happens for lower levels of credit quality bonds typically. High-yield bonds are similar to stocks in this manner. Thus, the addition of high-yield bonds to your portfolio can be a significant way to reduce overall portfolio risk.
- Reduce fluctuations of price-sensitive products in the portfolio – Certain assets that are part of your investment portfolio are more sensitive to interest-rate movements and overall stock market trends. This means these products significantly increase or decrease in value as per changes in market interest rates and other external market factors. Keeping a certain number of High-yield bonds can help to cover up these stocks or other sensitive assets.
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