Risks of High-Yield Investing

High-yield investments also have their disadvantages, and investors must consider higher volatility and the risk of default at the top of the list. Fortunately for investors, default rates are currently around 2.5 to 3% (as of August 2012, according to Fitch Ratings), which is near historic lows. However, you should be aware that default rates for high-yield mutual funds are flawed. The figures can be manipulated easily by managers because they are given the flexibility to dump bonds before they actually default and get downgraded and to replace them with new bonds.

How would you be able to assess more accurately the default rate of a high-yield fund? You could look at what has happened to the fund's total return during past downturns. If the fund's turnover is extremely high (over 200%), this may be an indication that near-default bonds are being replaced frequently. You could also look at the fund's average credit quality as an indicator; this would show you if the majority of the bonds being held are just below investment-grade quality at 'BB' or 'B' (Standard & Poor's rating). If the average is 'CCC' or 'CC,' then the fund is highly speculative ('D' indicates default).

Another pitfall to high-yield investing is that a poor economy and rising interest rates can worsen yields. If you've ever invested in bonds in the past, you're probably familiar with the inverse relationship between bond prices and interest rates: "as interest rates go up, bond prices will go down." Junk bonds tend to follow long-term interest rates more closely; these rates have recently stabilized, thus keeping investors' principal investment intact.

During a bull market run, you might find that high-yield investments produce inferior returns when compared to equity investments. Fund managers may react to this slow bond market by turning over the portfolio (buying and selling to replace the current holdings), which will lead to higher turnover percentages and, ultimately, add additional fund expenses that are paid by you, the end investor.

In times when the economy is healthy, many managers believe that it would take a recession to plunge high-yield bonds into disarray. However, investors must still consider other risks, such as the weakening of foreign economies, changes in currency rates and various political risks.

Source: http://www.investopedia.com/