Value Investing

The Intrinsic Problem With HY Bonds

Most investors who invest in bonds are going after the “guaranteed interest” that bonds provide. Even with a $1 million, a 2.5% yield will only provide $25,000 in income that will provide unsatisfactory to most people.

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High Yielding Bonds
Image source: DonkeyHotey - Flickr

It is thus natural that investors would seek better returns by buying bonds with higher yields.

Unfortunately, there is no free lunch in the world. Every percentage point of interest more translates to more risk – even if it is not apparent to investors.

What this means is that investors are taking on a higher likelihood of their initial investment (the principal amount) being impaired down the road in exchange for 1% to 2% more interest a year.

This may all sound very theoretical – but the recent crisis in the Oil & Gas sector has proven otherwise.

The Intrinsic Problem With High Yielding Bonds

Just because you’re investing in a bond does negate the need for fundamental analysis.

Companies typically raise money from the high yielding bond market for expansion. It can be a developer choosing to buy land, a manufacturer buying land and machinery for a factory, a shipping company buying ships and related vessels.

The common thing for all these companies is that their business plan must succeed for them to generate the capital needed to repay back investors.

In others words, investors must be able to assess the likelihood of such projects being successful if they want to get their money back.

When we look at stocks, we look for companies with strong financial positions. We look for companies with fortress-like balance sheets with strong cash flows.

Unfortunately, when you look at high yielding bonds of companies looking to raise debt – these things will be absent which is the exact reason why are they forced to pay the interest rates they do!