When talking about investing in capital or investing funds we think in earning incomes with the lowest risks as possible or even risk free. The problem is that in this day’s instrument that can be considered almost “risk free” -the Treasure Bonds of the US Government- are giving poor returns. For example, the 5 year Treasury Notes is giving lees than 1% of annual yield (US Department of the Treasury, 2011), clearly less than the past 12 months Consumers Price rise, so probably investing in these instruments will make you lose money because of the inflation.
With this reality, what options are available in the market?
If we think in high potential revenues, there is an instrument called Junk Bond, or High-yield Bonds, that are similar to regular bonds, but are not investment-grade issues. One of their characteristic is that “the interest that they generate is higher than that of the usual ones. These high interest payments compensate the investors for the extraordinary risks they take. These are high yield due to the high risk” (Gass, 2011), the high risk comes from the nature and credit quality of the issuer and the chance of not repaying the loan.
Commonly, the issuers are companies or corporations with some suspect credit ratings, less financial strengths or in sectors with significant amount of capital needs like Telecommunications or Energy. John Lonski, Chief Economist for Moody´s Analytics says that “Currently, high-yield bonds yield 7.18 percentage points more than comparable Treasuries. Bear in mind that junk bond´s yield is like a thermometer. The higher the yield, the more risk you´re taking” (Waggoner, 2011).
Sounds like more than a respectable yield, but what are the risks involved investing in this type of Bonds? According to William Morgan, Senior High-yield Portfolio Manager from J.P. Morgan Asset Management, “defaults are the biggest hazard in the junk market, analysts also try to predict how much can be salvaged when they occur. The average recovery has run at 44 percent” (Hershey, 2011).
But, what’s the worst that could happen? In the 12 months ended November 2008, the average junk fund lost 30 percent, including interest (Waggoner, 2011), and we are talking about one of the worsts financial crisis since the 1930s.
It seems that at this moment risk is under control, Matt Eagan Co-manager of the Loomis Sayles Bond fund “noted that despite weak economic growth, American companies are enjoying hefty profits, indicating that they cannot only handle interest and principal payments on their bonds but also can take advantage of today’s low interest rates should they need to refinance” (Hershey, 2011).That means that the default rate is likely to remain low, and is quite unlikely to rise much above 5 percent even if the economy skids back into recession, he said.
Well, like all in life nothing is black or white, specialist recommend investing in a well-diversified portfolio, which should contain a mix of corporate, federal, municipal, mutual funds, stocks and junk-bonds. The important for potential buyers is to check fund´s portfolio, to make sure it is not committed to more low-quality risk than they want and is not overly concentrated in certain industries.
Would you take the risk?
US Department of the Treasury (2011, 11). Retrieved on November 24, 2011 from http://www.treasury.gov
Gass, Davis (2011, 11). Weighing The High Risks And High Returns Of Junk Bonds. ABC Article Directory. Retrieved on November 24, 2011 from http://www.abcarticledirectory.com
Waggoner, John (2011, 11). Junk Bonds: Yield vs Risk. Retrieved on November 24, 2011 from http://www.postcrescent.com
Hershey, Robert D. (2011, 10). High Corporate Profits May Reduce Risk in High-Yield Bonds. The New York Times. Retrieved on November 24, 2011 from http://www.nytimes.com
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