High-yield investments can be desirable to income investors. After all, receiving a high rate of return for prolonged periods of time can significantly accelerate the wealth-building process. Unfortunately, these investments often come riddled with significant risks that can destroy wealth rather than create it.

Types of high-yield investments

High-yield investments exist across many different asset types. However, when discussing this topic, investors usually refer to one of two asset classes.

High-yield stocks

Not all businesses offer impressive capital growth rates. Eventually, even the most successful companies will start to mature, resulting in growth grinding to a halt. But cash flow generation can often remain strong, and subsequently, the business rewards loyal shareholders with sizable dividends instead.

Dividend-paying UK shares offer an average yield of around 4%. But numerous stocks offer yields higher than 8% or even 12%.

As exciting as these high-yields sound, there’s always a giant caveat to keep in mind regarding stocks. Unlike interest payments on bonds, dividend payments to shareholders are 100% optional for a business. And, therefore, can be cut, suspended, or even outright cancelled.

When the operating environment becomes tough or disaster strikes, companies quickly eliminate unnecessary spending to reserve resources. And while management teams often try to avoid cutting dividends, this income commonly ends up on the chopping block when serious problems emerge.

This is how high-yield investment traps are made.

For example, in early 2020, Carnival, a cruise line operator, announced that its ships would remain parked in the harbour following the pandemic outbreak to prevent the spread of Covid-19 amongst its customers. This, of course, meant revenue and profits were going to suffer significantly, and unsurprisingly the share price plummeted. But since the dividend yield rises when the share price falls, it reached levels higher than 20%!

Anyone who saw this high yield and bought shares to capitalise on it was bitterly disappointed. A few weeks later, management announced that dividends were being outright cancelled until further notice. As of November 2022, dividends have still not resumed.

Of course, there are some exceptions. And several companies within the FTSE 100 have sustained a high dividend yield for many consecutive years.

Some examples of historically sustained high-yield UK stocks include:

• British American Tobacco (LSE:BATS)
• National Grid (LSE:NG)
• Rio Tinto (LSE:RIO)

High-yield bonds

High-yield bonds typically come in the form of corporate bonds with low credit ratings. As a quick reminder, a bond is a form of securitised debt that a company can issue to raise capital.

Whenever a bond is created, it’s assigned an investment grade by credit rating agencies. These financial institutions look at the financial health of the issuing enterprise to determine the probability of the company being able to repay the debt and interest when it matures. If the issuing business is thriving and generating plenty of cash flow, it will receive a high credit rating. Alternatively, a financially struggling company will receive a low credit rating.

These ratings can help an investor make a more informed investment decision regarding risk. Low-rated bonds have a higher risk of default, potentially leaving an investor with nothing. However, these bonds also offer significantly higher yields to compensate for this. And if a low-rated business successfully repays the loan and interest, the fixed income generated can be pretty lucrative.

Having said that, this is often not the case. And even if the issuing company doesn’t go bankrupt, it may still default on its loans, making the high-yield bonds worthless. This is why these are commonly referred to as “junk bonds”.

Bond credit ratings explained

Each credit rating agency has its own classification system. The table below lists each rating from highest to lowest and shows which ratings are equivalent between agencies.

The following list explains what each rating means. The S&P ratings are displayed below, but the same explanation applies to equivalent grades from other rating agencies.

• AAA – These bonds are considered “prime” and, therefore, highly unlikely to default.
• AA+ to AA- – These bonds are considered “high grade”. They are riskier than prime bonds but still have a very low risk of default.
• A+ to A- – These bonds are considered “upper-medium grade”. There is a higher risk of default than in AA bonds.
• BBB+ to BBB- – These bonds are considered “lower-medium grade”. While still considered relatively safe, these bonds carry some notable risks.
• BB+ to BB- – These bonds are considered “speculative”. There is a notable probability that they will default.
• B+ to B- – These bonds are considered “highly speculative”. There is a significant chance that they will default.
• CCC+ – These bonds are considered “substantial risks”. There is a very high chance of default.
• CCC – These bonds are considered “extremely speculative”. It’s incredibly likely to default in the future.
• CCC- to C – The bonds are considered “default imminent”. These bonds are expected to default soon with little chance of recovering.
• D – These bonds are considered “defaulted”. These bonds are in default, and investors will likely end up with nothing.

Any bond with a rating of BB+ or below is considered a high-yield investment or “junk bond”. Any bond with a rating of BBB- or higher is considered “investment grade”.

Advantages of high-yield investments

Despite the abundance of risk, high-yield investments still carry some notable advantages that make them popular among some investors.

• Higher returns – A carefully selected portfolio of high-yield bonds or stocks can provide a sizable stream of passive income far exceeding the stock market or bond market average.
• Comeback potential – Not every low-rated corporate bond belongs to broken businesses. Some are firms in the process of turning themselves around, while others are small enterprises slowly climbing the ranks. Over time, credit-rating agencies may update the investment grade on a bond as the risk of default falls while the yield remains high.
• Diversification – High-yield investments can provide portfolios exposure to new wealth-building avenues. Similarly, it’s possible to buy a bond ETF or mutual fund that invests in an extensive collection of junk bonds to mitigate the risk of default while still capturing the benefits of high yields.

Disadvantages of high-yield investments

While the advantages can persuade an investor to allocate some capital to these types of investments, it’s essential always to consider the drawbacks.

• High Risk – A high-yield bond is often issued by struggling companies that may not have the means to keep up with interest payments, let alone repay the principal. Similarly, high-yield dividend stocks could face significant financial pressures that often result in a cut or complete cancellation of payments. In either scenario, investors could lose money rather than make it.
• Liquidity issues – Low-grade bonds can be challenging to sell due to the poor quality of the asset. This is especially true for bonds consistently downgraded or stocks that are verging closer toward bankruptcy.
• Fluctuations in interest rate – Upward movements in a variable interest rate cause bond prices to fall, and vice versa. As such, even if the company successfully meets their financial obligations on time, investors can still end up with a negative return on investment.
• Price volatility – High-yield bonds and stocks have a reputation for greater price volatility which can adversely impact the performance of an investment.

What’s a realistic yield on an investment?

Every bond or stock is a unique case that offers different return rates. However, what is a realistic rate of return investors should expect?

As previously mentioned, UK shares provide a dividend yield of around 4% when looking at the companies inside the FTSE 100.

As a general rule of thumb, most investment analysts agree that a yield of up to 6% can be sustainable. Anything higher than 6% could be dubious and require more scrutiny. However, an exception is usually made for Real Estate Investment Trust (REIT). Due to the legal requirement of this corporate structure to pay out 90% of net earnings as dividends, it’s not uncommon to see dividend yields higher than 6% for these stocks.

What about bonds?

In 2019 the Montana Department of Revenue investigated the average return of corporate bonds across all credit-risk ratings.

Other types of high-yield investments

While high-yield bonds and stocks are a primary area of focus for fixed income-seeking investors, other financial instruments are gaining popularity.

• Exchange-traded funds (ETFs) – Instead of investing directly into high-yield investments, investors can buy shares in an ETF that pools together capital from all shareholders to invest in a portfolio of high-yielding assets. For example, corporate bonds, municipal bonds, and in some rare instances, government bonds. Mutual funds are another investment vehicle that can take the form of a bond fund.
• Closed-end funds (CEFs) – Closed-end funds work similarly to ETFs. However, there is a limited number of shares restricting the number of investors able to invest. These are typically a lot more exclusive and, therefore, can be difficult to resell at a later date.
• Peer-to-peer lending – New fintech platforms are emerging that enable investors to lend money to consumers directly. These loans are typically short-term, and the credit risk of borrowers is on display for investors to see. But it can still carry high-interest rates. However, due to their unsecured nature, they are also high risk.
• Real estate investment trust – This type of investment vehicle trades like a regular stock. But rather than having an underlying business, these consist of a management team that oversees a real estate portfolio. The owned properties are leased out to companies or consumers, collecting rental income that’s passed onto shareholders as a dividend. A variant of this is the Mortgage REIT, where the management team instead invest in mortgage debt rather than rental properties, returning the income received on mortgage payments to shareholders using dividends.
• Cryptocurrencies – Some digital tokens pay interest payments with more crypto for simply holding them in an account. The strategy is yield farming within the crypto community and can generate impressive returns. However, cryptocurrency prices are notoriously volatile, making it a risky strategy to pursue.

The bottom line

Finding and buying the highest-yielding bonds and stocks may seem like a fantastic investment decision for getting rich quickly. But often, investors can be left with nothing when not considering the risks. It’s also important for an investor to consider their general investment objective to ensure this is a suitable asset class for their investing strategy.

Chosen carefully, high-yield investments can provide meaningful wealth-building returns even for those seeking a fixed income. But they are often high-risk investments and, therefore, only suitable for investors with a relatively high-risk tolerance. For those that aren’t willing to take on these risks, sticking to investment-grade bonds may be the more prudent strategy.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Saima Naveed does not have a position in any of the financial instruments mentioned in this article. The Money Cog does not have a position in any of the financial instruments mentioned in this article.