When you invest, your goal is to earn the most money possible in the shortest amount of time. In order to achieve this, some investors follow a practice known as high-yield income investing.
The idea behind this investment thesis is simple. By investing in companies and municipalities that are considered to be underdogs, you have the ability to beat the returns of the overall market.
But what exactly is high-yield income investing, and what are the pros and cons of incorporating this strategy into your portfolio?
What Is High-Yield Income Investing?
In the income strategy, yields refer to the amount of income you generate in relation to the price you paid for the investment. For example, if you make $5 annually from a $100 investment, the yield on that investment is 5%.
High-yield investing can relate to investments in a wide variety of asset classes, with the key being the fact that the investment generates more income than the average yield in its space. The most common high-yield investments are stocks and bonds, but there are also various alternative investment options. Here’s how it all breaks down:
What Is a High-Yield Bond?
High-yield bonds, or junk bonds, are corporate bonds that pay higher yields to the bondholder than the average across the bond market. The higher interest rates, or coupon rates, paid on these bonds is the result of the investor’s willingness to purchase bonds from an issuer with a poor credit rating, generally a rating below BBB.
Like any other bond, these are fixed income investments, giving the investor fixed payments that they know the amount of before purchasing the investment. However, because junk bonds are issued by companies with poor credit scores, the default rates on these investments are high compared to investment-grade bonds, adding to the risk associated with owning them.
There are two different types of junk bonds:
- Fallen Angels. Fallen angels represent bond issuers that had a good credit rating at one point, but have recently been downgraded. This is commonly seen during tough economic times as corporations struggle to produce the profits they enjoyed during economic expansions.
- Rising Stars. A rising star is a junk bond issued by a corporation that has seen significant improvements as of late. As a result, the issuer may be upgraded by credit reporting agencies, turning its bonds into investment-grade bonds.
What Is a High-Yield Stock?
High-yield stocks, like their bond counterparts, are stocks that pay higher dividend yields than the average in their sector. These are generally attractive to income investors because stocks that pay high dividends tend to lack volatility while offering reliable income generation. But it’s also important to understand why a company’s dividend payouts outpace the average among its peers.
In some cases, high dividend yields are simply the result of a solid business model. Some companies know how much they are likely to grow and are able to allocate a large portion of their profits to dividend payments.
On the other hand, some high dividends in the stock market may be a sign of trouble. Some companies have high yields simply because the value of their stock has taken a tremendous hit. Therefore, the dividend in relation to the price of the stock ends up being higher than average. There’s no telling what may have caused the declines without a bit of research, but this is often the result of unease in a particular market, cash flow issues, or other operating concerns.
So, before jumping into a high-yield stock, make sure you know why it offers higher-than-average dividend payments.
What Are Alternative High-Yield Investments?
Finally, there are several alternative investments that pay high yields as well. Some common examples include:
- Real Estate. Buying real estate with the goal of renting it out has the potential to net significant monthly income for the investor. However, there are headaches to consider because you won’t generate income unless a renter is renting the property and paying their bills. Rentals in unpopular areas will be difficult to rent out and will require a reduction of monthly rental costs, cutting into your profits and potentially leading to losses.
- Tax Liens. Tax liens are another high-yield income investment. Investors purchase these liens with the goal of collecting past-due taxes, plus interest, from the property holder. However, tax liens come with their own risks to consider. For example, the property owner may not pay back the taxes they owe, resulting in a legal battle with the property owner for your returns.
Pros and Cons of High-Yield Investing
High-yield income investing is an exciting process. Not only will you generate consistent, predetermined income, but if you’ve made the right investment decisions, your investments will experience valuation growth that will help you build wealth over time.
However, as with any investment model, high-yield income investing isn’t suitable for everyone. There are pros and cons to consider before getting involved.
Pros of High-Yield Investing
There are plenty of benefits to investing in high-yield income investments. Some of the most significant perks to doing so include:
- Income. The name of the game with these types of investments is income, and who doesn’t like bringing extra money through the doors on a regular basis? Making the right decisions with income investments results in consistent cash you can depend on, usually on a quarterly or annual basis.
- Stability. High-yield investments in assets like dividend stocks tend to provide slow, steady growth for investors, taking minimal hits during bear markets. These companies tend to be well-established with highly predictable returns, making them a great option for newcomer investors or investors with a low risk tolerance.
- Beat the Market. Making the right decisions when investing in high-yield investments gives you the opportunity to beat the average returns seen in popular benchmarks like the S&P 500 and Dow Jones Industrial Average.
Cons of High-Yield Investing
While there are plenty of benefits to high-yield investing, there’s no such thing as a perfect investment. There are some drawbacks to consider before diving in, the most significant of which include:
- Higher Risk. Some high-yield investments, like real estate and real estate investment trusts (REITs), come with higher levels of risk. Both REITs and other real estate investments depend on a wide range of variables, the most important of which is rental rates.
- High Default Rates. When most investors talk about high-yield income investments, they’re referring to junk bonds. However, before diving into these bonds hoping for a bigger-than-average payday, it’s important to remember that these bonds have much higher default rates than investment-grade bonds. When a company defaults on its debts, the investor isn’t paid back on time — and in some cases, may not be paid back at all.
- Liquidity. Many high-yield investments require you to hold your money in them for long periods of time. If there comes a time when you need to access your money, you may find it difficult to do so, or you might have pay fees to exit your positions.
- Yields Change Over Time. An investment that’s offering a high yield today may not offer a high yield tomorrow. With a lack of liquidity among many high-yield investments, you may find yourself trapped in a loser.
Diversification Is Key When Investing for High Yields
Regardless of which direction you go with your income investing endeavors, it’s important that you keep diversification in mind. Diversification is the process of spreading your investment dollars across a wide range of assets, an action that results in a form of insurance.
If one investment results in significant declines, the gains you experience in the other investments in your portfolio help to offset the losses, ensuring that your overall portfolio doesn’t take a big hit.
Since most high-yield investments are either investments in companies that have been dealt a tough hand to contend with, or highly speculative investments in alternative markets, maintaining a diversified portfolio when investing to maximize yield is absolutely essential.
Investors who want exposure to high-yield junk bonds and stocks but don’t want to pick out their own individual investments can gain the exposure they’re looking for through exchange-traded funds (ETFs) focused on high-yield bonds or high-dividend stocks. These funds pool money from a large group of investors and invest it in a diversified group of high-yield investments. Some of the most popular of these funds include:
- High-Yield Bond Funds: iShares iBoxx $ High Yield Corporate Bond ETF (HYG), SPDR Bloomberg Barclays High Yield Bond ETF (JNK), and iShares Broad USD High Yield Corporate Bond ETF (USHY).
- High-Yield Stock Funds: Global X Nasdaq 100 Covered Call & Growth ETF (QYLG), SPDR Portfolio S&P 500 High Dividend ETF (SPYD), and WisdomTree Emerging Markets High Dividend Fund (DEM)
Should You Consider Adding High-Yield Investments to Your Portfolio?
Now that you know the basic pros and cons of getting involved in high-yield investing, the million dollar question is whether you should add these income-generating assets to your investment portfolio. Unfortunately, like most questions in the world of finance, the answer isn’t a one-size-fits-all solution.
First and foremost, there are several types of high-yield investments to choose from, the vast majority of which are high risk. The one exception to the rule is quality high-dividend-yield stocks like world-leading energy companies. These stocks often fit well as part of the diversification strategy within any portfolio.
Other high-yield investments like junk bonds, real estate, and tax liens come with much higher levels of risk and aren’t a good fit for most investors. The best candidates for these types of investments are people who are interested in generating the highest level of income possible from their investments and are comfortable with the risks they will need to take to do so.
Generally, these investments are best for younger investors who have a long time horizon. In their case, if things go well, they earn a higher-than-average return that can compound mightily over the long term. However, if things go wrong, they have plenty of time left to recuperate from the losses.
By contrast, older investors closer to retirement and those with a lower tolerance for risk should steer clear of high-risk, high-yield investment vehicles.
High-yield investments often seem like the way to go at first glance. After all, who doesn’t want to make more money through their investments?
However, before diving in, it’s important to consider the risks. As is just about always the case in the market, in order to have the potential to generate higher returns, you must be willing to accept a higher level of risk.
Moreover, not all high-yield investments are created equal. Before diving into any investment, you should do your research and get a good understanding of what you’re buying when you shell out your hard-earned cash.