It may surprise you to know that some of the top companies in the Fortune 500 have had debt obligations that were below investment grade - otherwise known as "junk bonds." For example, in 2005, automotive icons Ford and General Motors both fell into junk bond status for the first time in either company's history. Many investors would not pass up the opportunity to buy common stock in these companies, so why do so many avoid these companies' bonds like the plague? It may have something to do with price fluctuation and with the fear that past abuses, like those of Michael Milken - the controversial financial innovator also known as "The Junk Bond King" - might be repeated.

Although they are considered a risky investment, junk bonds may not deserve the negative reputation that still clings to them. In fact, the addition of these high-yield bonds to a portfolio can actually reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation. We will explain what high-yield bonds are, what makes them risky and why you may want to incorporate these bonds into your investing strategy.

SEE: Junk Bonds: Everything You Need To Know

Why the Bad Reputation?
During the 1980s, Michael Milken - then an executive at investment bank Drexel Burnham Lambert Inc. - gained notoriety for his work on Wall Street. He greatly expanded the use of high-yield debt in corporate finance, and mergers and acquisitions, which in turn fueled the leveraged buyout boom. Milken made millions of dollars for himself and his Wall Street firm by specializing in bonds issued by "fallen angels" - companies that experienced financial difficulty, which caused the price of their debt, and subsequently their credit rating, to fall.

In 1989, Rudy Giuliani (then the U.S Attorney General of New York) charged Milken under the RICO Act with 98 counts of racketeering and fraud. Milken was indicted by a federal jury. After a plea bargain, he served 22 months in prison and paid over $600 million in fines and civil settlements. Today, many on Wall Street will attest that the negative outlook on junk bonds persists because of the questionable practices of Milken and other high-flying financiers like him.

Defining High-Yield Investments
Generally, high-yield bonds are defined as debt obligations with a bond rating of Ba or lower according to Moody's, or BB or lower on the Standard & Poor's scale. In addition to being popularly known as "junk bonds," they are also referred to as "below-investment grade." These bonds are available to investors as individual issues or through high-yield mutual fund investments. For the average investor, high-yield mutual funds are the best way to invest in junk bonds, as these funds were formed to diversify a pool of junk bonds and reduce the risk of investing in financially struggling companies.

SEE: What Is A Corporate Credit Rating?

Advantages of High-Yield Bonds
Many good companies run into financial difficulty at various stages of their existence. One bad year for profits or a tragic chain of events may cause a company's debt obligations to be downgraded to a level below investment grade. Because of these additional risks, high-yield investments have generally produced better returns than higher quality, or investment grade, bonds. If you are looking to get a higher yield within your fixed-income portfolio, keep in mind that high-yield bonds have typically produced larger returns than CDs, government bonds and highly rated corporate issues.

High-yield bonds do not correlate exactly with either investment-grade bonds or stocks. Because their yields are higher than investment-grade bonds, they're less vulnerable to interest rate shifts, especially at lower levels of credit quality, and are similar to stocks in relying on economic strength. Because of this low correlation, adding high-yield bonds to your portfolio can be a good way to reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation.

Another factor that makes high-yield investments appealing is the flexibility that managers are given to explore different investment opportunities that will generate higher returns and increase interest payments. Finally, many investors are unaware of the fact that debt securities have an advantage over equity investments if a company goes bankrupt. Should this happen, bondholders would be paid first during the liquidation process, followed by preferred stockholders, and lastly, common stockholders. This added safety can prove valuable in protecting your portfolio from significant losses, thereby improving its long-term performance.

The New High Yield
If you're looking for some big yield premiums, then emerging market debt securities may be a good addition to your portfolio. Typically, these securities are cheaper than their U.S. counterparts are, because they have a much smaller market, yet they account for a significant portion of global high-yield markets. What else could you be purchasing when investing in high-yield funds? One addition is a leveraged bank loan. These are essentially loans that have a higher rate of interest to reflect a higher risk posed by the borrower. Some managers like to include convertible bonds of companies whose stock price has declined so much that the conversion option is practically worthless. These investments are commonly known as "busted convertibles" and are purchased at a discount, since the market price of the common stock associated with the convertible has fallen sharply.

To help diversify their investments even further, many fund managers are given the flexibility to include high-yielding common stocks, preferred stocks and warrants in their portfolios, despite the fact that they are considered equity products. For portfolio managers looking to tailor duration and short the market, credit default swaps offer a credit derivative that allows one counterparty to be long a third-party credit risk and the other counterparty to be short the credit risk. In essence, one party is buying insurance and the other party is selling insurance against the default of the third party.

SEE: When To Short A Stock

Risks of High-Yield Investing
High-yield investments also have their disadvantages, and investors must consider higher volatility and the risk of default at the top of the list. Fortunately for investors, default rates are currently around 2.5 to 3% (as of August 2012, according to Fitch Ratings), which is near historic lows. However, you should be aware that default rates for high-yield mutual funds are flawed. The figures can be manipulated easily by managers because they are given the flexibility to dump bonds before they actually default and get downgraded and to replace them with new bonds.

How would you be able to assess more accurately the default rate of a high-yield fund? You could look at what has happened to the fund's total return during past downturns. If the fund's turnover is extremely high (over 200%), this may be an indication that near-default bonds are being replaced frequently. You could also look at the fund's average credit quality as an indicator; this would show you if the majority of the bonds being held are just below investment-grade quality at 'BB' or 'B' (Standard & Poor's rating). If the average is 'CCC' or 'CC,' then the fund is highly speculative ('D' indicates default).

Another pitfall to high-yield investing is that a poor economy and rising interest rates can worsen yields. If you've ever invested in bonds in the past, you're probably familiar with the inverse relationship between bond prices and interest rates: "as interest rates go up, bond prices will go down." Junk bonds tend to follow long-term interest rates more closely; these rates have recently stabilized, thus keeping investors' principal investment intact.

During a bull market run, you might find that high-yield investments produce inferior returns when compared to equity investments. Fund managers may react to this slow bond market by turning over the portfolio (buying and selling to replace the current holdings), which will lead to higher turnover percentages and, ultimately, add additional fund expenses that are paid by you, the end investor.

In times when the economy is healthy, many managers believe that it would take a recession to plunge high-yield bonds into disarray. However, investors must still consider other risks, such as the weakening of foreign economies, changes in currency rates and various political risks.

The Bottom Line
Before you invest in high-yield securities, you should be aware of the risks involved. If, after doing your research, you still feel these investments suit your situation, then you may want to add them to your portfolio. The potential to provide attractive levels of income and the ability to reduce overall portfolio volatility are both good reasons to consider high-yield investments.

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