Right time to consider high yield?

Fidelity Viewpoints — 08/04/10

Higher current income from these bonds can help buffer price volatility.

Current low interest rates and low yields on more conservative fixed-income investments have left many investors searching for higher yields. If you fall into this camp, you may want to consider the relatively higher yields associated with non-investment-grade bonds, also known as high-yield bonds. These securities, however, aren’t for everyone—especially those investors who are risk averse. But, if you are an investor who can tolerate a higher level of risk and volatility, they may offer some advantages.

What are high-yield securities?

High-yield securities are viewed by both analysts and investors as riskier than those issued by companies with stronger balance sheets and higher credit ratings.

Credit-rating agencies—such as Standard and Poor's, Moody's, and Fitch Ratings—evaluate the ability of public companies, governments, and other borrowers to make income and principal payments to their debt holders. The debt of those organizations best prepared to do so is rated "investment-grade" (BBB and higher), while the debt of those most vulnerable to default is rated "non-investment-grade" (BB and lower).

Distressed companies and leveraged companies—due in large part to their relatively high ratio of debt to equity—tend to struggle more than better-capitalized companies during economic downturns. To compensate for taking on increased risk, such as default risk, the debt of these companies typically offers higher yields, hence the term "high yield."

A prudent time to consider high yield?

There are two reasons to consider investing in this sector:

1. High current income
With the 10-year Treasury bond yield hovering in the low 3% range through mid-July, the average yield for taxable high-yield bonds was 8.73%, a difference of nearly six percentage points.

2. High coupon can mitigate price declines
In addition to receiving income, high-yield investors have the potential for capital appreciation if the price of their bond or bond fund improves. The combination of the relatively high yields and the potential for capital appreciation can lead to better returns for high-yield bonds as economic conditions improve. If they don’t, high yields can protect against a certain amount of price depreciation.

The default rate, too, has been steadily declining and is not generally expected to negatively impact the asset class in the coming months. It is important, however, to remember that past performance is no guarantee of future results.

Who may want to consider high yield?

An allocation to high-yield securities may be appropriate for an investor who is well diversified, risk tolerant, and has a long-term investment time frame. Typically, these types of securities also appeal to investors looking for additional income and the potential for capital appreciation.

Next steps

There are many ways to invest in the high-yield bond asset class, including mutual funds, exchange-traded funds (ETFs), or individual high-yield bonds. Given the inherent credit risk associated with these types of bonds, it is important to diversify across many different issuers from different industries. For the average investor, it may be appropriate to seek this type of diversification through a diversified investment vehicle like a mutual fund or ETF.

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Disclosure: I hold a High Yield Mutual Fund and a High Yield ETF.