Imagine investing in a fund that built bigger and bigger dividends until you were ready to use them. Sound good?
I’ve always been a fan of high yield bonds as an asset class for this reason. My clients and I earned solid results by investing in these products.
Today, boys and girls, we’ll explain what a high yield bond is, how it reacts to different pressures and the method I’d recommend to buy a high yield bond if I were a beginner.
What is a High Yield Bond?
Let’s begin with the word “bond.”
Most people are comfortable with the idea of a stock. If you own stock in a company, congratulations! You are now the proud owner of a piece of that firm. How will you make money? Like any company owner, you’ll generally come out ahead as the company’s business prospects improve. If the company takes a downturn, you could stand to lose your entire investment.
A bond is better for people who don’t want that roller coaster ride. Instead, bond holders are more comfortable loaning a company money. The company gives you specific terms (for example: five years at a six percent interest rate), and you agree to loan them the money.
In essence, you aren’t a company owner. You’re Louie the Loan Shark. Sweet!
How Do I Decide Which Bond to Buy?
Well, Louie the Loanshark, what’s the first question you’re going to ask if you’re loaning someone money?
That one’s easy: How likely is it that I’ll get my money back?
In the case of High Yield bonds, it’s pretty shaky. If these companies were regular people, they’d be the type that’ve had their American Express Card taken away and their house payment is two months behind.
When I said Loan Shark, I meant it.
So, when you see bad credit, what do you do? You jack up the interest rate. If I’m going to risk my money, I’m going to need to see a good return. High yield bonds are the highest returning bond type on the market. You’ll receive much higher returns than any other type of bond because you’re taking more risk.
High yield bonds used to be called junk bonds. To dress up the category, somebody decided “high yield” was a prettier name. I’d agree.
Is This Category Too Risky For Me?
Maybe. It depends on your goals. But let’s mitigate the risk of buying a single bond.
If you’re a new investor, I wouldn’t try to purchase an individual bond (loan money to one company). Frankly, the risks in that arena are too high for a beginner, unless you’re completely open to the risk of losing all of your capital.
In this case, I prefer a mutual fund. With a fund you have humans buying and selling positions on the open market. Fund managers diversify the portfolio like an ETF would, but also can sell when a certain company starts to turn for the worse. You don’t want to worry about that.
Let’s Talk About Performance and the Dividend
In high yield bond funds the dividend usually is classified as interest, so this asset class is best used in your tax sheltered plan (RRSP or IRA).
First, you can expect the value of your fund to fluctuate. With a high yield bond fund, I’ve always considered this the roll of the ocean. If I still own the shares and they’re pumping out a dividend, I have one goal: make that dividend grow.
Therefore, I reinvest dividends.
That purchases more shares, which I reinvest in the mutual fund. I’m always looking at the size of my dividend payment that’s reinvested and asking “is it large enough to supplement my income yet?” Until it is, I continue to reinvest.
One of my clients pretended the dividend was a little man who worked alongside him each month. Every dividend would head back into the factory to help make the next payment a larger amount.
Popular High Yield Bond Investor Questions
How much should I invest?
With any investment, you begin by finding the return you need to meet your goal. For some investors, high yield bonds will be too risky for their portfolio. For others, they’ll need growth in their portfolio and high yield will rarely give you huge returns.
How risky is a high yield bond fund?
I present the risks of a high yield bond as “high” because I want investors to understand the risk versus other bonds. However, on a long-term risk/reward pyramid, high yield bonds are less risky than large cap stocks. If you’re comfortable investing in stocks, a high yield bond mutual fund historically has been less risky.
If I Don’t Have an IRA or RRSP Should I Still Invest?
I prefer to use tax advantaged investments outside of a tax shelter and tax-creating assets inside of shelters. High yield bonds are heavily taxed when compared to other asset classes that earn a similar return. You can use a high yield bond mutual fund outside of a tax shelter, but realize you’ll pay more tax than you will with many other investment classes.
How to I Find a Good High Yield Bond Mutual Fund?
Read our pieces on using Morningstar to find good funds:
Part II: Evaluate a Mutual Fund in 10 Minutes
Not only will you see past performance, but this website will tell you about fees and how much you’ll need to invest to meet fund minimums.
Okay, that’s my story. Do you use high yield in your portfolio? Are there criteria or tools you use to choose high yield bonds that are appropriate for a new investor that weren’t presented here? We’d love to hear them.