Whenever issuers offer bonds and their credit rating is not investment grade, issuers generally must offer a higher yield in order to compensate for the increased risk they ask investors to take on. These high-yield or so-called junk bonds are attractive to specific investors because while the class as a whole is riskier, it also offers a higher yield over investment-grade securities. This means with the proper information available and due diligence, opportunities for investors to achieve far higher ROIs on their investments exist in this market.
This is particularly true at times like now when interest rates are still low. Many interesting opportunities for large returns exist for investors willing to explore the high-yield market in such an environment. While yields are higher than inflation and volatility is less than the stock market, this makes high-yield securities attractive for “yield-hungry” investors in the fixed-income universe. Moreover, savvy investors, both institutional and retail, can use junk bonds in order to further diversify their portfolios. (See also: The Effects of Rising Interest Rates on Junk Bonds.)
However, it must be clear that these investments are high yield precisely because of an increased level of risk. Therefore, it is vital to look closely at all the risks associated with any particular issuer before purchasing the security. In general, there are multiple issues to consider before investing in bonds, for both institutional and retail investors.
Importantly, retail investors have more difficulty accessing and evaluating relevant information regarding higher-yielding bonds than do professional or institutional investors. (See also: Junk Bonds: Everything You Need To Know.)
Challenges for Private Investors
For obvious reasons, private (retail) investors who lack the resources of their institutional counterparts have a more difficult time assessing, compiling, trading, and analyzing bonds. It can thus be a tricky course to navigate for such individual investors.
The primary difficulties are (1) the lack of relevant information about high-yield bonds, (2) the fact that several high-yield bond issues are often not traded on official stock exchanges, and (3) a substantial number of high-yield bonds are issued only in high denominations (100,000 USD or 100,000 EUR). In the United States, in fact, there are multiple bonds available with a minimum investment amount of 1,000 USD; however, in the euro arena these types of bonds are more rare. A primary example of how this plays out for private investors is that they take on higher risk because they do not have sufficient capital to adequately diversify the risk of high-yield bonds, or even simply do not have the opportunity to invest in certain securities.
On the other hand, institutions usually have both the capital and opportunity for more attractive high-yield offerings. In large part, this is due to the greater access to information such institutions enjoy. While complex databases of this information are offered by entities such as Bloomberg, they are cost-prohibitive for private or retail investors. Therefore, the need for in-depth examination of high-yield bonds is of crucial importance to private investors while also becoming more cumbersome and problematic due to, in large part, their lack of access to the information that their institutional counterparts have. In general, institutional investors have more extensive information, for example regarding sourcing, marketing and country analysis, specific company analysis, and technical analysis. Moreover, not uncommonly, large institutional investors additionally have a direct link to the management of the issuers.
Clearly, any rash decisions by investors (particularly private) concerning the purchase or sale of a high-yield bond in response to rumors and unsubstantiated news, without having the proper experience or knowledge of the bond market, may yield negative results and even extreme losses.
Information Efficiency, or Rather Information Inefficiency
Of particular interest are the results of a study by Ying (2006) that indicate that the stock market has greater information efficiency than the bond market does. This study goes on to examine how often information about bonds arrives and the impact of this information on the price of bonds throughout the business day (much like stocks). Ying’s study found that “there are differences in price durations between corporate bonds and stocks, and for a given company, the persistence of the impact on adjusted price duration is normally higher for stocks than bonds.” As described by NASDAQ (2016), the efficiency of the availability of information on these securities has a significant bearing on the market’s ability to correctly price and reflect accurate and true information about a particular asset’s value. In a theoretical “informationally efficient market” where information is efficiently disseminated, price changes will be insignificant to non-existent when such information is released. In this hypothetical market, any change in value or price would be the result of individual interpretations by separate investors based upon their own individual analysis.
The Bottom Line
Particularly in an “information inefficient” market (when compared to the stock market for instance), information is crucial for investors in the higher-yielding bond market. It seems far more difficult for private investors to access and evaluate highly relevant information regarding this type of security. Institutional investors usually have distinct advantages. In large part, this is due to their greater and more efficient access to significant information. (See also: Junk Bonds: Too Risky in 2016?)