In a world where government bonds and savings accounts offer miniscule interest rates, investors have been stretching for yield — which is to say, going far beyond their comfort zones to take on higher-risk investments.

Robust yields can help generate impressive annual payouts, but many investors may be stretching too far to reach them.

#-ad_banner-#It’s tempting to go after that kind of yield, but any investment that promises double-digit payment streams could carry a lot more risk than you might imagine. Here’s how to identify these risky assets so that you can avoid them by any means necessary.

One way investors pursue such high payouts is through junk bonds, which are offered by companies with uncertain futures that must provide very high interest rates to line up demand for their bonds. Of course, for any given investment, a direct correlation between perceived risk and the enticements needed to lure investors compensates for that risk.
 
So how do you find the line between aggressive and risky?

Well, if you come across a bond that offers an effective yield below 6%, it is likely safe. Understand that bonds, after they are issued, rise and fall in value depending on whether they are perceived to be safe or risky. So if a company initially issued a junk bond with an 8% yield, and investors have determined that future bond payments almost surely will be made, they will buy the bond. That pushes it up in price, forcing the after-market yield to be lower. That’s why you should pay attention in this instance to the current bond yield (6%) and not the original issue yield (8%).

The converse is also true. A junk bond that is seen by savvy bond traders as too risky will offer an after-market yield that is even higher than the “when-issued” yield. So if that bond that initially offered an 8% yield now offers an even higher yield in after-market trading, then you should see that as a big red flag.

Of course, investing in the junk bonds of any particular company means that you’ll be out of luck if that company runs into deep trouble. That’s why many investors prefer to hold a basket of junk bonds through exchange-traded funds (ETFs) such as iShares iBoxx $ High Yield Corporate Bond ETF (NYSE: HYG) or the SPDR Barclays High Yield Bond ETF (NYSE: JNK). Each fund offers impressive yields while spreading risk around.

Action to Take –> The investing maxim, “Bulls make money, bears make money, pigs get slaughtered,” surely applies to junk bonds. It’s wise to seek the best yields possible only after you’ve done your homework.

Remember that you should track the current yield — and not the “when-issued” yield. If you are looking to buy a newly issued junk bond, know that it is quite risky if it is initially offered with a yield in excess of 8%. That kind of payout seems tempting, but it’s wiser to take a pass.

This article originally appeared on InvestingAnswers.com:
“When Is A High-Yield Bond Just Too Darn Risky?”

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