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Risk and Reward in High Yield Investing

Investing in high yield bonds can be a great way to increase your returns, but they inherently come with a greater degree of risk. Many financial advisers automatically steer their clients away from this arena, unwilling to put their reputation behind riskier assets. But that doesn’t mean you should necessarily stay away. Just understand and know what you are doing.

Find out now: How should I save for retirement?

Before making any investing or trading decision, it is imperative that you understand both what you are buying into and the instrument being used for the transaction. Less experienced investors will often thoroughly research the former, while neglecting the latter. This can easily lead to losing money even when buying stock or bonds of a good company. Understanding the mechanism of your investment is especially important when it comes to high yield investing.

What is high yield investing?

This term typically refers to the purchasing of bonds in companies, governments, or municipalities that are rated below AA, or below investment grade. The term also sometimes refers to other strategies which can generate a high yield, such as floating-rate bank loans, or Mortgage REITs, but these are sometimes difficult for individual investors to participate in, so we will focus on high yield bonds.

When it comes to bond holdings, many risk-averse funds such as 401ks are not allowed to hold bonds with less than a AA, or sometimes even AAA rating. For this reason, bonds below investment grade are also known as “junk bonds.” Because the companies or governments issuing these bonds have been identified as having a higher risk of default, they must pay a higher yield in order to attract investors.

Playing the high yield game

Now comes the importance of the second half of the investing equation mentioned above—understanding and choosing the correct instrument for your trade.

The days of buying a bond and holding it through maturity maybe over. Say you identify a company whose financials you find attractive even though their bonds are rated poorly. Even better, you see a sector that you believe is poised to do well. Thanks to the many investment instruments available today, you can protect yourself by purchasing an ETF in the bond sector that interests you, such as iSharesiBoxxHigh Yield Corporate Bond Fund (HYG), thus remaining liquid in case the financial picture begins to change. The low rating is in place because of a likelihood for default. This is your risk. But the ratings agencies can’t know when or if this default will occur, and therein lies your potential for gain.

A good example of this is the situation with the bonds of the countries on the periphery of Europe. Greek, Italian and Spanish bonds have been paying high yields now for years, as the imminent threat of default hangs over their governments. The last thing any investor wants to do is buy a ten year bond issued by one of these governments, but traders have been making a killing by holding exposure to Greek, Italian and Spanish debt for shorter periods of time, via ETFs such as Global X FTSE Greece 20(GREK).

Determine your Risk Appetite

The platitude “never bet more than you are comfortable losing” is often applied to high yield investments. However no one ever feels comfortable losing their hard earned cash.  So the thing to always keep in mind for individual investors is that these instruments are meant to be used as trades, not as traditional investments. Due to the availability of liquid ETFs you can make a savvy trade that only exposes you to risk for days or even hours. They are not designed to be held long term.

If you both keep your risk within your comfort zone, and use the proper instrument to remain liquid, high yield investing can bring you solid returns while still allowing you to sleep at night.

Gregory Phillips
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