Covered Bonds
February 12, 2025
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In the previous article, we understood about how high-yield bonds have emerged as one of the biggest market segments in the fixed income securities market. However, before an investor decides to commit a part of their portfolio towards high yield bonds, they must be aware of the various types of advantages and disadvantages that these bonds offer.
This article will critically evaluate the commonly stated pros and cons of the high yield bond market.
The main reasons which draw investors to commit their money to high yield bonds have been listed below:
The price of high yield bonds is not affected as much by external interest rates as by the financial position and credit rating of the firm issuing the debt. As a result, it can be said that high-yield bonds provide a significant upside potential as compared to traditional bonds. This feature lures in many investors who have a larger risk appetite.
There are several well-known disadvantages of high-yield bonds. Some of these disadvantages have been mentioned below:
For instance, a company may float an issue of high yield bonds when their financials are not in order. Over time, they may improve their credit rating and as a result, the bond value may increase.
If the company calls the bonds at such time to avoid paying higher yields promised to the investors, then it could result in a loss to the investors. To make matters worse, the premature calling of bonds is quite common with high-yield bonds.
Trends in empirical data clearly indicate the high yield bonds rise significantly more as compared to the average debt security in times when the market is good. However, when the overall market is bad, high-yield securities tend to be the worst. The number of defaults that happen in high yield securities tends to multiply during recessions.
Hence, investors who choose high yield bonds often face reinvestment risks wherein they constantly have to find newer investment options assuming that their investment will be returned to them within a short period of time.
The fact of the matter is that high-yield bonds are only suitable for seasoned bond investors who are comfortable taking large risks. The average risk-averse bond investor would be better off avoiding such an investment.
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