Question: J.D. in Highland County: With inflation still high, are high yield bonds a good way to beat it?
A: Whomever coined the phrase ‘high-yield bonds’ should win the ‘marketer of the year’ award if such a thing exists. Because that’s really just another way to say ‘junk bonds.’ And at the end of the day, which sounds more appealing?
With that in mind, here are some important basics to keep in mind about junk bonds. First, they’re a type of corporate bond issued by a company that at least one of the three main ratings agencies (Moody’s, Fitch, or Standard & Poor’s) has rated below ‘investment grade.’ Basically, this means there’s a higher risk that the company might default (AKA, miss its interest or principal payments) or go bankrupt. That’s why the yield is higher – the company needs to entice investors to make-up for that increase in risk. (Though, we should note, if a company would have to file for bankruptcy, bondholders are actually paid before shareholders.) So, the trade-off, as always, becomes risk versus reward. Plus, how do you handle market turbulence? Because volatility in junk bonds is actually very comparable to the stock market – not to other types of bonds.
As for if they’re a way to beat inflation? Potentially. But remember, we’ve just entered a rising interest rate environment where bond values tend to drop with rising interest rates – and while junk bonds have historically been less sensitive to interest rate movements than other types of bonds, that can always change.
The Simply Money Point is that every investment comes with some kind of risk, and junk bonds are no exception. Whether or not you buy any really depends on your risk tolerance and how they would fit into your overall financial plan. Because why take on excessive risk if you don’t need to?