The Federal Reserve will likely keep interest rates low for the foreseeable future. That means retail investors will continue to search for risky, high-yield instruments.
The rise of exchange-traded funds makes it easier to access this niche asset class but average investors need to be wary.
High-yield investments are often called junk bonds because the bonds sold by the debt issuer aren't investment-grade. High yield is characterized by the classic example of taking a higher risk for a higher reward.
Non-investment grade bonds typically carry Standard and Poor's ratings of BB and lower; these are high-yield ratings for bonds.
With safer U.S. Treasury bond yields just slightly above inflation rates, people investing for income are buying these vehicles, experts say.
Jody Lurie, a director and corporate credit analyst for the investment strategy group at Janney Montgomery Scott, says investors become more comfortable with risk, they are picking investments by what they think they should be getting in return, which ends up making them less diversified since the risk is concentrated.
"If you want to have a return of 5% or more, there are only so many asset classes that actually provide that," she says. "High-yield corporate debt happens to be one of them."
Scott Roberts, head of the high yield team at Invesco Fixed Income, says while high-yield bonds are riskier, since 1980, the high-yield market has had only five years of negative total returns.
"That really speaks to the power of the interest payments and coupon," he says.
Junk bonds offer investors solid returns, but with commensurate risks. There are three main ways retail investors can access high-yield investments: single-issue high-yield corporate bonds, high-yield mutual funds and high-yield ETFs.
Here's what you should know about high-yield investments:
-- High-yield investments require serious research.
-- High-yield bond funds offer diversification.
-- Mutual fund and ETF differences.
High-Yield Investments Require Research
Investors who are interested in buying individual corporate bonds should begin their due diligence by reviewing if a company has positive cash flow versus just looking at profitability, Lurie says.
"If a company is generating cash, they can pay off the bonds," she says. "As a bond investor, what do you care about? You care about getting your coupon payments on time and you care about getting your principal back."
Look if the firm is growing organically, rather than just getting bigger because of acquisitions. Compare how it is doing versus its peers to get a sense of how the industry is doing as a whole, she adds.
Owning a single-corporate bond is risky, Roberts says, even if the company itself looks solid. "It's having all your eggs in one basket," he says.
High-yield Bond Funds Offer Diversification
High-yield bond funds offer diversification since many of these contain several types of assets from different issuers. Roberts says mutual funds and ETFs may hold hundreds of names, which limits how much a single default affects the whole fund.
Bill Merz, head of fixed-income research at U.S. Bank Wealth Management, says they recommend retail investors to look at well-diversified, actively managed mutual funds with strong track records across various economic environments. Active managers can make decisions to buy or sell holdings at any time.
"High-yield investing is more about avoiding losers, and bond investing in general is more about avoiding losers and finding winners because your total return is capped," he says. "You're never going to receive more than par plus the coupon payments."
Merz and Lurie say in the high-yield market, don't equate strong track records with significantly high returns during good times. "That just means they're taking more risk," Merz says. "It's about managing through difficult market environments and avoiding some of the larger losses."
There have been only a few times of distress in high-yield markets in the past 10 years, so investors may have to dig deeper to find those managers with strong track records. Merz says investors can check how a manager handled energy investments in 2016 when crude oil prices fell below $30 a barrel, which caused some energy companies to default.
Mutual Fund and ETF Differences
Most mutual funds are actively managed, while most ETFs follow a passive index and rebalance holdings on a set schedule, experts say.
Roberts says ETFs can provide generic market exposure, while actively managed mutual fund investors might want to be overweight or underweight in certain sectors where the investor thinks fund managers can take advantage of mispricing.
The structure between mutual funds and ETFs differ, and the experts say investors should keep this in mind.
ETFs typically offer daily transparency, letting investors know what they always hold, while mutual fund holdings are only required to be released quarterly. ETFs are easier to sell during volatile times.
With mutual funds, for investors to get their money, fund managers need to sell securities to return the money. That can make investors more exposed to market sell-offs and difficulty getting their money back if market liquidity dries up.
Roberts says the biggest risks with investing in high-yield bonds happens if the economy is headed into a recession. That's when there are more defaults because corporate profits fall and companies can lose money.
"Companies have less free cash available to pay down debt if the earnings are falling," he says.
Signs to watch for possible weaknesses in high-yield markets are whether the Fed is tightening interest rates as that makes credit market conditions tighter.
Roberts says investors should also listen to what companies say about their outlook for capital expenditures and business development.
"If we see companies start to pull back on investment that can be a clue that things are slowing," he says.
Merz says U.S. Bank Wealth Management is "neutral" on high-yield debt right now. While investor sentiment for junk bonds is generally positive as credit spreads are tight and interest rates are low. That makes borrowing costs low for corporations.
The flip side means a lot of companies have loaded up on debt and investors are receiving lower-than-historically-normal compensation for these risky bonds.
"Those are the things that prevent us from being overweight on high yield," he says.
Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.