Although they are considered a risky investment, high-yield bonds—commonly known as junk bonds—may not deserve the negative reputation that still clings to them. In fact, the addition of these high-risk bonds to a portfolio can actually reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation.

Let's look more closely at what high-yield bonds are, what makes them risky and why you may want to incorporate them into your investing strategy. High-yield bonds are available to investors as individual issues or through high-yield mutual funds.

Defining High-Yield Bonds

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." Being rated this way means, essentially, that the company's financials are shaky, and the possibility that the firm could miss making interest payments on their debt, or go into default altogether, is higher than those of "investment-grade" bond issuers.

Having its bonds classified as "below-investment grade" implies a company is badly or dishonestly run, and not long for this world. But many good—even blue-chip—corporations 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. It may surprise you to know that some of the top companies in the Fortune 500 have had this happen: For example, in 2005, the debt issued by automotive icons Ford and General Motors both fell into junk bond status.

The opposite is true, too: The bonds issued by a young or newly public company may be low-rated because the firm doesn't have much of a track record or financial results to evaluate.

Whatever the reason, being considered less creditworthy means borrowing money is more expensive for these companies. They have to pay more interest on their debt, the same way individuals with low credit scores often pay a higher APR on their credit cards. Hence, the namesake high yields on the bonds the companies issue: The interest rate is larger because of the additional risks.

Advantages of High-Yield Bonds

As a result of the increased interest rate, high-yield investments have generally produced better returns than higher quality, or investment grade, bonds. And not just highly rated corporate issues; high-yield bonds have typically produced larger returns than CDs and government bonds. If you are looking to get a higher yield within your fixed-income portfolio, keep that in mind. Advantage number one of high-yield bonds: income, income, income.

The performance of high-yield bonds does 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 a company's economic strength. Because of this low correlation, adding high-yield bonds to your portfolio can be a good way to reduce overall portfolio risk. They can act as a counterweight to assets that are more sensitive to interest-rate movements or overall stock market trends.

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, taking some of the sting out of the danger of default.

Why the Bad Reputation of High-Yield Bonds?

If they have so many pluses, why are high-yield bonds derided as junk? 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," once-sound companies that experienced financial difficulty, which caused the price of their debt, and subsequently their credit rating, to fall.

In 1989, Rudolph 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.

Risks of High-Yield Bonds

That being said, high-yield investments also have their disadvantages, and investors must consider higher volatility and the risk of default at the top of the list. Although corporate loan default rates are low, averaging around 3% in 2018, the level of corporate indebtedness is rising, not just in the U.S. but around the world. That troubles many analysts and economists, who think a reckoning is bound to come due soon.

You should also be aware that default rates for high-yield mutual funds 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." Though they are less sensitive to short-term rates, junk bonds do tend to follow long-term interest rates closely; after a long period of stability, which kept investors' principal investment intact, interest rates have been slowly rising since late 2017.

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.

Alternatives to High Yield Bonds

If you're looking for some big yield premiums, domestic junk bonds aren't the only asset in the financial sea. Emerging market debt securities may be a good addition to your portfolio. Typically, these securities are cheaper than their U.S. counterparts, because they have a much smaller market, yet they account for a significant portion of global high-yield markets.

Another possibility: Leveraged bank loans. These are essentially loans that have a higher rate of interest to reflect a higher risk posed by the borrower. Some fund 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.

The Bottom Line

For the average investor, high-yield mutual funds are the best way to invest in junk bonds as these funds offer a pool of low-rated debt obligations; the diversification reduces the risk of investing in financially struggling companies.

Before you invest in high-yield bonds or other 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.