Understanding High-Yield Bonds & How They Might Fit Into Your Portfolio
How Bonds Benefit Investors
Looking for better ways to balance your portfolio? Many investors like bonds as a way to reduce volatility and manage risk. What is a bond? Well, a bond is a loan that governments, corporations or municipalities issue when they want to raise capital. Investors who buy these bonds are essentially loaning money. Much like a loan, bonds pay interest to the investor until the bond matures and the principal becomes due.
Well-constructed bond portfolios are considered part of a diversified fixed-income strategy in an investor’s portfolio. Oftentimes, people heading into retirement look more towards fixed-income strategies to preserve wealth. Depending on the type of bonds, some are less correlated than others and some are even negatively correlated to the equity markets. This low or negative correlation makes bonds a perfect addition to a diversified portfolio.
What types of bonds are available?Â
The highest-quality bonds are investment-grade bond funds rated as such by bond-rating agencies. There are five main types of these bonds: treasury, savings, agency, municipal and corporate bonds. The treasury will issue treasury bonds and bills at auction to raise funds for operating the federal government. The treasury department also issues savings bonds for individual purchase. Agency bonds are issued by federally backed agencies such as Fannie Mae and Freddie Mac. Certain cities issue municipal bonds, which are tax-free but carry slightly lower interest rates than corporate bonds. Corporate bonds are issued by different companies and are riskier in general, but the tradeoff is they offer higher interest rates to investors.
High-yield bonds
These bonds fall into the riskier category because they aren’t investment grade and carry lower credit ratings than investment grade, but do offer higher interest rates and greater potential returns as the tradeoff. There are two main types: either fallen angels, formerly investment grade but the company’s credit quality dropped and rising stars, headed back towards investment grade after previously being downgraded.
Bond-based securitiesÂ
You can also get the benefit of bonds, without actually buying one. How? Buying securities that buy lots of these securities within an investment product. These include bond mutual funds, which hold a collection of different types of bonds inside each mutual fund. Another example of a pooled investment product is an exchange-traded fund (ETF). Certain ETFs own a pooled collection of bonds inside of them. When you own an ETF or a Mutual Fund you are in essence a holder of the underlying securities. As such, you will receive the return from those underlying securities. ETFs and Mutual Funds are a really easy way to get exposure to lots of individual bonds with one single purchase.
Are bonds safe during inflation?
To be honest an inflationary environment isn’t the most ideal time to invest in most bonds. When interest rates go up, most bonds value will go down. The longer the duration of the bond, the more it will be impacted by increased interest rates. There are some bonds that can perform well in increasing interest rate environments. Floating rate bonds, for example, adjust their interest rate levels at regular intervals (many times, every 90 days). With increasing interest rates, a floating bond will adjust its interest payout to a higher rate. This limits the impact of increasing interest rate environments. Another bond that can hedge inflation is a treasury inflation protected security (TIPS). The interest rate at issue does not change, however the bond principal will adjust to inflation changes. So the higher the value of the bond, the higher the coupon payment of the TIPS security, all else equal.
Taking a strategic approach to investing, particularly in today’s climate can help you not only protect, but maximize your income. Learn more about bonds and whether they might be the right fit to diversify your portfolio.