Are high-yield bonds worth the risk?

Bonds, yields, gilts, coupons... the terminology alone is likely to put you off getting to grips with the role high-yield bonds could play in helping you save for your future. But as with any type of investment, it’s important to understand the facts before deciding if (or if not) high-yield bonds could play a part in your long-term investment portfolio.

Here’s a quick recap of the ‘need to knows’ of bonds more generally. If you’d like a bit more information about how they work and their potential pros and cons The M&G Guide to Bonds is a really useful tool to help you brush up on the basics. And if you need some help with some of the terms used in this article, you can take a look at our glossary too.

What are bonds?

In short, if you are interested in receiving a regular income from your money, and not comfortable with too much risk to your money, investing in bonds (debt securities) could be a good option. 

• A bond is more or less an IOU that can usually be traded in the financial markets just as equities (shares in a business) are traded
• If a company, government or official agency wants to borrow money, they can issue a series of bonds to investors
• The bond issuer should give you regular interest payments in return for the ‘loan’; these payments are known as ‘coupons’. The issuer should also give you the original amount back at the end of the loan term, also known as its maturity date.

Of course, there’s always a chance that interest payments will stop or that you won’t be repaid your original investment, which is one of the key risks you face when investing in bonds, also known as default risk. 

Which bonds are right for you?

To start with, there are government bonds and corporate bonds. Both types are used to raise money, whether that be for public spending or to finance an acquisition or future growth plan for a business. 

These bonds, if issued by a company or government with solid finances like Germany or the UK, are generally regarded as lower risk, as they are less likely to default. They are rated as “investment grade” by credit rating agencies. On the other hand, these less risky bonds also tend to pay lower levels of interest. 

For investors comfortable with taking a greater level of risk in exchange for the opportunity to see higher returns over the long term, high-yield bonds could make things a little more interesting. 

What makes high-yield bonds different?

A company or government with a relatively low credit rating – below “investment grade” - could be considered a “high yield” option. The issuer has a greater risk of failing to meet their repayments, so they offer a higher level of interest to compensate for this. 

And while taking on more risk might not sound all that appealing at first, some high-yield bonds could actually be a good option for the right type of investor, at the right time. 

What causes a lower credit rating?

A company could have a lower credit rating and be considered high-yield for a variety of reasons. They could lack a track record, like a “start-up” company for example. They might have suffered a recent financial blow due to COVID restrictions, which could be a temporary position. Others might have made recent, but unproven changes to their boards or made a series of acquisitions yet to prove their worth in the markets.

The point is that just because a bond issuer is currently rated lower than others, it doesn’t necessarily mean the bond will fail (default). But of course, it is always a possibility.

Diversifying with high-yield bonds

An important point to make is that even though high-yield bonds may be considered riskier than some other bonds, they’re still regarded to be less volatile – meaning their prices fluctuate less -- than company shares (equities), particularly in high inflation environments. As such, investors pursuing high-yield portfolios, who may traditionally lean more towards equities to help them reach their goals, might also look to high-yield bonds at times of rising interest rates. 

High-yield bonds aren’t particularly sensitive to interest rate rises when compared to other bonds. Rates usually rise as an economy grows, which can mean consumer spending and company profits grow too, which is generally positive news for high-yield bond issuers. High-yield bonds can also potentially offer a level of diversification to an equity-heavy portfolio, reducing risk while still offering the potential for higher returns than more traditional bond funds, in our view.

It’s all relative

The truth is that high-yield bonds could offer a form of middle ground between generally riskier stockmarket investments and less volatile, lower-risk but lower-return bonds. For some investors -- depending on their financial ambition and appetite for risk -- this may feel like a good place to be.

But when it comes to investing, there are no guarantees. 

While high-yield bonds are by no means the riskiest option out there for investors looking for long-term returns on their money, they are best suited to those investors who have sought financial advice and are comfortable with taking on more risk than with other types of bonds. 

The value and income from the fund’s assets will go down as well as up. And this will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

The views expressed in this article should not be taken as a recommendation, advice or forecast. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.

Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund.

High yield bonds usually carry greater risk that the bond issuers may not be able to pay interest or return the capital.