If you’re an investor in search of income, chances are you’ll constantly be on the lookout for higher yielding investments. And that makes perfect sense. You naturally want the best return for your money. Who wouldn’t, right?
Indeed, the whole premise behind RateHub’s GIC and high-interest savings account sections is to allow consumers to find the best rate available. By putting a wide variety of rates on our site, we basically do the comparison shopping for you.
Of course, there are other ways to get a return on your money and some of these investments offer the potential for substantially higher returns. High-yield bonds and dividend stocks are two examples that could provide a much greater return than a savings account or GIC.
So what are they and should you buy them?
First, let’s look at high-yield bonds. These are bonds (the debt) of companies that are considered to be below investment grade. What this means is that the issuer isn’t seen to be as credit-worthy as a more solid company. Put another way, the reason the bonds offer such a high return is because there’s a risk that the bondholders won’t get paid back. That’s why they’re sometimes referred to as junk bonds.
If you buy a high-yield bond and the company makes its interest payments, the returns can be phenomenal. You’ll leave safer investments in the dust with annual returns of usually more than 5%.
But it’s important to note that with the chance for higher rewards comes greater risk.
Put yourself in the shoes of someone who purchased the bonds of Sprint back in September. As The Wall Street Journal recently reported, Sprint sold billions of dollars worth of bonds to investors that paid 6.75% at the time. But investors have soured on the bonds and they’re now trading at a 25% discount to their offering price. What this means is that if you wanted to sell the bonds before they matured, you’d only get 75 cents on the dollar compared to your original investment. Conversely, if you hold onto the bonds, the market is signalling that there’s a heightened risk Sprint may not be able to pay you back.
Closer to home, many energy companies’ bonds are now trading in junk territory given the collapse in oil prices. Bond investors are increasingly skeptical that the debts of these issuers will be paid back in full. As a result, prices of the bonds have tanked. Yields move inversely to price, so someone looking at the bonds may be tempted by the lure of a potentially high return. But again, there’s a huge amount of risk. If a company in the oil sands, for example, goes bust, a bond investor may not get much, if any of their money back.
High yields also present themselves in stocks. For example, some mining companies now sport dividend yields in excess of 10%. Much like junk bonds, these are very tempting for investors.
And again, you have to tread carefully. In the current low-interest rate environment, a stock with a 10% yield is one of two things:
- a bargain for those with the guts to buy it; or
- a company that’s likely to cut its dividend.
When a stock has a high yield (in other words, the dividend payout is high relative to the stock price), you can see it either as a threat or an opportunity. It’s an opportunity if the company can keep paying investors the dividend at the current rate. But the potential threat is that the company won’t be able to sustain its payout and thus the current high yield is something of a trap that investors should avoid. Anything above, say, 5% to 6% is a high-yield dividend stock. Don’t forget, stocks are riskier and much more volatile than bonds.
How do you know whether a particular high-yield stock is an opportunity or a threat? As a general rule, you want to look at whether the company’s earnings are sufficient to keep paying shareholders the current dividend. If the earnings outlook is plummeting, chances are good the company will have to slash its dividend in order to conserve cash. For people who bought the stock hoping to receive the high yield, disappointment is likely to follow. On the other hand, sometimes you come across a gem of a company that’s unloved, underappreciated, or whose prospects may improve. In this case, buying the stock may be a wise decision.
Admittedly, most dividend stocks (and we’d add investment grade bonds) aren’t incredibly speculative or on the verge of collapse. While they may come with higher risk, they may well be likely to sustain their interest and principal payments and dividends. Over time, stocks in particular do tend to be a crucial part of a balanced portfolio and dividends are an integral part of an investor’s returns over the long run.
Nevertheless, when you’re looking at something that pays a yield that seems too good to be true, keep in mind that it often is. That juicy return you’re eyeing? It could turn into a painful loss.
Flickr: Andreas Poike