Understanding high yield investments

The term ‘high yield’ sounds like a great opportunity to be able to boost your investment income and enjoy positive returns… but you need to be mindful of the associated risks.

While some high yield investments are certainly beneficial to include within a diversified portfolio, you should always do your homework.

Tim Farrelly, our external asset allocation consultant, gives us his insight into high yield and explains how there is a great deal of difference between excellent funds offering solid returns and those at the other end of the quality spectrum.

High yield investments are a generic asset class that can seem very attractive, but they are also quite inconsistent. Tim explains:

“The best way to explain high yield investments is to understand that it is all debt… it is money lent for a specific purpose that is promised to be paid back under certain circumstances – at a certain interest rate.

One proportion of the debt market is described as ‘investment grade’, which basically means there’s a really high chance you’ll be paid back as per the terms, but there is also ‘non-investment grade’ which is the high yield investments. These are also known as junk bonds and they will be repaid ‘if they can’. There is still a reasonable chance you’ll get your money back… but there is more risk involved.

As a result of this risk, they pay a much higher rate of return. For example, if you took out a term deposit today – which is Government guaranteed, you’d receive 0.4-0.5% per annum. In the high yield market, you could receive somewhere from 4-8%. But you do have to understand that there is the possibility of credit failure… where loans aren’t paid back, and you don’t receive the entire amount you invested.

Within high yield there is an enormous spectrum. On one end, investments look sound with a good return, but if things go badly, you might lose 10% of your money. However, down on the other end, if things go badly, you could lose everything. And because of that, when we start looking at high yield, we want to be very diversified.”

Business credit ratings are a key part of investment classification. Typically, a business would seek a rating from one of the large rating firms such as S&P or Moody’s. The organisation provides the rating agency with the details of the business, cash flow and other relevant financial information and receives a rating accordingly. Tim continues:

“The AAA rating is the highest and is as good as the Government. An A or BBB rating is investment grade, but only just… then there’s BB, B or lower than that and it’s recognised that there’s a significant chance the business would fail. This is why, in the ‘high yield, non-investment grade’ classification, you have to pay 7% interest instead of 3%. The higher the risk of the business loan, the higher the rate of interest you need to pay… it all relates to how much risk someone is subjected to by investing.”

Currently, high yield investments form part of Bucket 2 within a portfolio. Tim outlines why they do very well within the intermediate bucket:

“I like to describe them with a broad statement… if growth equities in our Bucket 3 have 100 units of risk, then our high yield investments in Bucket 2 have about 30 units of risk… and cash in Bucket 1 has zero risk. I believe they are about a third as risky as equities. But if markets keep going as they are and expected returns from high yields start to match, then we could reach a stage where we start looking at these types of investments not only for Bucket 2 but also Bucket 3.

We like high yield, but you have to be careful, you need to do your work and find high quality operators that have a lot of diversification. Make sure you are getting paid for the risk you are taking on.”

Here at First Financial, we partner with our clients to help them build their wealth in line with their unique circumstances and attitudes to risk.

Our approach is an innovative Investment Philosophy and when we create investment portfolios, we make sure they are robust enough to endure market volatility… while still delivering the required income.

If you are interested in learning about our strategy or want to find out more about high yield investments, please contact us today.