What is High Yield?
Investing in stocks or bonds that have relatively higher yields compared to other assets (such as cash investments) is known as “high-yield” investing. High-yield assets are typically equity securities that pay dividends or interest rates over 6% and have market values (i.e. not over-the-counter stocks) greater than $300 million. Fintalent’s High Yield Consultants explain that a certain stock trading at $50 might pay an annual dividend of $2 per share or 4% ($2/$50). This stock would be considered a high-yield asset if it traded above the 6% threshold or if the market capitalization (market value) was higher than $300 million.
High yield investing is mainly used by investors that seek both income and long-term appreciation potential. It also often referred to as “junk” bond investing because many of the assets that fall under this category have relatively low credit quality. That said, all high-yield assets should not be considered risky. For example, U.S. REITs (real estate investment trusts) with market values of more than $600 million and that have relatively high yields are considered relatively safe. Why? Because real estate is a tangible asset that is typically not subject to future changes in the economy such as a recession where corporate earnings might take a temporary hit.
Investing in High Yield Assets: Risks
Since high-yielding assets are typically less stable than other investments such as cash, they also often carry more risk (they might drop in value and cause you to lose money). This is because these types of assets might be more volatile and since they pay relatively high yields, investors might be willing to sell them at a greater rate. However, it is important to note that there are also opportunities for high profit potential when investing in high yield.
Broadly speaking, the risks associated with investing in high yield can be divided into four categories:
- Leverage: High-yield asset generally come with higher leverage and therefore this can increase their riskiness. This is especially true for small companies where large amount of cash flows in from operations or debt issuances by the company that have to be invested within a short time period (such as 6 months).
- Liquidity: High-yield assets are generally less available than other assets. That is, if an investor wanted to sell out at a given point in time they might be unable to do so because there are relatively less buyers of high-yield assets. For example, a REIT (real estate investment trust) pays relatively high dividends, but it can be more difficult to sell out of the REITs at a certain point in time because the supply of REITs trading on the market is relatively low.
- Growth: Companies that pay higher yields typically have lower growth rates (such as current price earnings ratios). That is, it is harder for them to generate the same rate of return as other assets that pay lower yields. -Leverage: As previously mentioned, high-yield assets are usually associated with higher leverage and this can be a risk if you don’t closely monitor your investment.
- Collateral: High-yield assets may be backed by collateral (many have property or hard assets that are easily liquidated). If a company goes out of business or faces declining cash flow, the collateral might not be able to cover the high yield.
- “House of Cards”: High yield investing involves taking chances on companies that might otherwise not be considered worthwhile investments by many investors if they were analyzed properly. Many of these companies are typically small and have relatively high market capitalizations, but they may also be risky due to their high yields or the fact that they are small. By investing in high yield securities you may be taking a chance on investing in small companies that have a higher risk of failing (and therefore losing money) than other investments.
Investing in High Yield Assets: Risks of High-yield Investments
Reasons to not invest in high-yield investments
A high yield asset may not be a good investment if you do not understand the company or evaluate its ability to pay back your investment with a sufficient rate of return. This is especially true if you are new to investing in high yield.
If you invest in a high yielding stock or bond that has a relatively low market capitalization, the company may go out of business.
Investing in high-yield assets is not free. You might lose money on your investment because of relatively high interest rates paid by the asset and because of volatility that these types of investments typically face (such as a company going out of business).
Reasons for Investing in High Yield Assets
A high yield asset might be a good investment if you have enough initial capital to efficiently buy the assets (either through buying at the IPO or from another large investor) and keep it for the long term. For example, if you invest $1000 in a high-yield asset, you might lose money if the asset goes down in value because of a business problem or decreased demand. However, if you are able to buy it at an IPO or large discount to its current price and hold it for the long term (over 10 years) you might see a significant return on your investment.
The main advantage of investing in high yield is that it offers both income potential and growth potential. High yield investments that pay high yields tend to have lower growth rates, but they can be considered relatively safe because they generally do not carry as much risk as other assets such as equity securities. -Buying high yield assets with relatively low market capitalization (such as small or mid-cap stocks) can be an effective way to seek high returns with greater risk than investing in large cap companies.
High yield investing may be a good way to diversify your portfolio because it is not correlated with other asset classes (such as equities, fixed income, and real estate). This means that there is a low correlation between the price moves of these two asset classes and therefore you can diversify your portfolio without increasing your risk. For example, if you are familiar with the basics of investing in equities, consider adding high-yielding investments to your portfolio.
If you invest in high-yield assets in an efficient manner (such as investing in a mutual fund that invests in multiple high yield assets), you can be more certain that your investment will grow at a certain rate. This is unlike buying high-yield assets directly, where the actual performance of the asset might be volatile.
High yield investing may help with reaching financial goals faster, such as paying off debt or saving for retirement. This is because you may want to reinvest income from other investments and take out money from a high yield investment later, rather than withdrawing and spending it now.
High-yield investments can be used to hedge against stock market losses and are considered to be a way for investors to diversify their portfolios by adding less-liquid and higher yielding investments in case the market does not perform as expected or a company runs into financial trouble. In other words, high-yield investments are meant for the most riskiest investors who want options on the most volatile securities out there. However, it is important to keep in mind that high-yield investment strategies can backfire when used without knowledge and proper analysis.