What Are High-Yield Investments & How Do They Work?

High-yield investments may seem attractive to many investors, especially after years of low interest rates on less volatile options. But there are many risks associated with high-yield investments that could damp returns and even wipe out your investment.

Understanding high-yield investments

The term “high-yield investments” usually refers to corporate bonds issued by companies with low credit ratings. Companies issue bonds to raise money as an alternative to selling stock or taking out a bank loan. Often, these companies are deeply in debt or face other financial stress. Investors who purchase bonds receive interest payments (also called the coupon rate) until the bond’s maturity date, at which point the borrowed amount is repaid.

In the same way that a consumer with a low credit score will pay more to borrow, companies that are deemed to be greater credit risks will be required to pay higher rates when they sell bonds. The good news for investors is that several credit-rating agencies evaluate the risk associated with high-yield corporate debt and assign each one a grade. This makes it easier to research and compare different investment opportunities.

Credit rating of high-yield investments

The credit-rating agencies break down their classifications into two categories: investment and speculative grade. Within each of those categories, you’ll also see a range of grades similar to school grades, with AAA being the best and C or D being the worst (depending on the agency).

Speculative-grade investments, also known as junk bonds, may have a higher yield but they also are considered to be at a greater risk of default. Even if the company itself doesn’t default and go out of business, it’s still possible for them to default on the terms of the bond agreement. That means you may not receive any or all of the interest or principal repayment when the bond’s maturity date arrives.

“High-yield investments” can also refer more broadly to a variety of assets that offer the potential for returns that top the market average. These assets are often volatile, making them a risky addition to an investor’s portfolio. There could also be a great deal of price fluctuation, making it stressful to monitor and manage a high-yield investment account.  And because high-yield bonds and other instruments have the real potential for defaulting, it’s possible for investors to lose everything.

What is a high-yield stock?

In addition to high-yield bonds, you may also come across high-yield stocks  and wonder how they differ from other types of high-yield investments. These typically refer to stocks that pay dividends, meaning investors receive a regular payout for each share. These aren’t necessarily all that risky and may simply signify that a company isn’t  in an aggressive growth mode; instead of reinvesting profits in the business, they are returning cash to investors.

Advantages of high-yields investments

High-yield investments come with a few different advantages.

1. Higher yields

The primary attraction of junk bonds and other high-yield investments is the potential for loftier returns compared to investment-grade bonds. Evaluate each investment to determine the risk and reward. Bonds are popular, but there are other types of high-yield investments.

2. Potential for credit-rating upgrades

Another benefit is that not all companies that issue high-yield debt are failing. Some are actually deemed so-called rising stars, meaning they are either new or regrouping and have the potential of earning a credit- rating upgrade. So although a company may be considered a junk bond today, it could evolve from speculative grade to investment grade.

In addition to looking at a company’s credit rating, you should also evaluate its disclosure documents, including the prospectus. These give insights into the company’s financials and cash flow to gauge how likely you are to receive your interest payments and the initial principal at maturity.

3. Diversification with funds

Finally, it is possible to diversify high-yield investments so you don’t put all your eggs in one basket. High-yield bond ETFs and mutual funds are available to help spread the risk across multiple companies and industries. Funds typically include hundreds of companies. Even if some default, you have a better chance of earning gains overall.

Disadvantages of high-yields investments

There are, of course, several drawbacks to high-yield investments.

1. Chance of default

The biggest is that there’s the chance of default, meaning the company won’t have the financial capacity to make payments on the bond, either on the interest, the principal, or both.

2. Illiquidity

Many types of high-yield investments aren’t very liquid and may have restrictions on when they can be sold. ETFs and mutual funds are typically considered more liquid choices. And if a company’s credit rating goes down, the market value of the bond will also drop. So even if you can sell, you run the risk of receiving less than your purchase price.

3. Economic volatility

Finally, there are several economic factors that hurt high-yield investments. Bond yield rates and interest rates have an inverse relationship. When interest rates rise because of inflation or faster economic growth, bond prices tend to fall.

Junk bonds tend to react more to adverse economic events. Setbacks in the broader economy can cause investors to sell bonds en masse as they switch to investment grade corporate and US Treasury bonds. This causes high-yield bond prices to fall, not to mention a greater potential for default if the economy runs into more serious trouble.

Examples of high-yield investments

There are several different options to consider when looking for the best high-yield investments:

• High-yield bonds:

  A high-yield bond is a corporate bond from a company with a low credit rating. It may need to raise capital to grow or to manage financial problems. Investors buy bonds, then receive interest payments (or coupons) over the life of the bond. Bonds can be sold at their current market value anytime before the maturity date, or at their maturity value when the term ends. The lower the company’s credit rating, the likelier it is to default on the bond agreement.
  

• REITs:

  A real estate investment trust, or REIT, lets you invest in real estate without having to actually buy properties on your own. Mortgage REITs tend to offer higher yield than equity REITS, which generally hold income-producing properties. Rather than collecting income through rent, mortgage REITs collect interest on real estate loans. Both types of REITs pay out dividends equal to 90% of profits to investors each year. And although returns are likely to be higher with a mortgage REIT, they tend to borrow more money, making the risk of default higher. They may also hold mortgage-backed securities, which can be volatile if there is a housing-market crisis as there was leading up to and during the Great Recession of 2007-2009.
  

• CEFs:

  Closed-end funds (CEFs) are similar to exchange-traded funds (ETFs) except that they issue a limited number of shares. You’ll need a brokerage account to buy CEF shares. The fund manager oversees the investments, often with a focus on assets in a specific industry. Yields may be higher, but there’s also an added level of risk. Because new shares can’t be created, CEFs often borrow to invest more and increase returns. Too much debt can lead to financial pressure, since CEFs don’t usually hold a lot of cash in reserve.
  

• P2P loans:

  Peer-to-peer lending involves investing in consumer loans and receiving  interest payments based on the borrower’s credit profile. P2P platforms assign each borrower a credit-risk rating, and you can diversify by spreading out your investment across multiple loans. P2P platforms refer to your investments as notes. You can opt to review and select your own investments, or automate the process by selecting your own asset allocation across each credit rating. Returns may be higher but there’s also the risk that borrowers default, especially since the loans usually are unsecured. In that event, you would lose your investment. P2Ps also tend to be illiquid and notes usually have to be sold at a discount.
  

• MLPs:

  Master limited partnerships (MLPs) allow investors to buy into a range of different projects, though they most often are associated with industries like gas, oil, and coal. Because of this, many MLPs come with the unique risk of new legislation and regulations that can reduce their profitability. Although MLPs are publicly listed on stock exchanges and are relatively liquid, they do have a complex tax treatment. As a pass-through entity, an MLP doesn’t have to pay corporate taxes. But investors do have to pay income tax on distributions. Additionally, you may be taxed on what’s known as unrelated business taxable income  earned by the MLP, which may not be protected even in tax-advantaged retirement accounts. This is a sophisticated, high-risk product that may require professional tax help as well.

The bottom line

Jumping into high-yield investments like corporate bonds of companies with poor credit ratings may seem like a quick way to turbocharge your portfolio. But there are real risks.

Because of this, the average investor may not want to jump headfirst into this segment of the market. Diversification is important, but high-yield investments aren’t necessary to achieve a balanced portfolio. Investors must have a strong tolerance for risk and be well-prepared to handle the financial setbacks that can come with high-yield investments. Make sure you’re comfortable losing that investment capital because there’s a chance you could.‍