Different investors have different goals.
But whether you are a risk-seeker looking to dabble in trading as a Wall Street hobbyist or you’re conservatively preparing your nest egg, the phrase “high yield” is attractive.
It can be challenging to know which high-yield investment options are just risky enough and which are too risky. By reading this article, you’re clearly placing importance on educating yourself, so you’re off to a good start.
Keep reading to understand what high-yield investments are, the various categories of high-yield investments, and the critical elements to consider as you continue to build your investment portfolio.
What Qualifies as a High-Yield Investment?
Yield refers to the income earned on an investment. For example, yield can take the form of interest received or dividend income earned from holding a security.
To get a higher return, you’ll have to venture into market-linked investments, not just fixed income investments. Those market-linked investments carry higher risk. To attract investors, issuers of such investments offer a higher yield to compensate for the higher risk involved.
What qualifies as “high” is going to be relative based on what type of investor you are. A conservative investor may consider a dividend stock with a 4% yield to be high yield, while a more aggressive investor may not.
While high-yield investments can offer you high returns, risk and reward go hand in hand. When considering investment options labeled as “high yield,” you should employ an educated approach and a healthy amount of skepticism.
Although you may be rewarded for tolerating more risk, it’s important to really consider what this risk will mean to your overall financial stability.
Key Considerations About High-Yield Investments
When considering high-yield investments for your investment portfolio, it’s always a good idea to ask yourself a few questions first. Think about what you’re hoping to accomplish and check in with yourself about how risk tolerant you can afford to be.
Why Invest in High-Yield Instruments?
Most investors are aiming for the good life — both now and in the future.
To say that 2020 put things like personal finance issues and unpredictability in the stock market “on blast” would be an understatement. We all witnessed how quickly investors without a long-term plan can be devastated. But many who were in a position to take advantage of the volatility did quite well since the market registered record highs in many sectors in the second half of that year.
One thing 2020 certainly proved is that diversification is always going to be important. A portfolio with a mix of conservative safe investments combined with higher-yield and higher-return instruments can be the way to go.
High-yield instruments can provide an additional source of income to fund retirement even if your portfolio finds itself in a bind.
How Risk Tolerant Are You?
Is your risk tolerance high enough for high-yield investing? Can you stomach watching the value of your investment fluctuate up and down?
One way to know is to ask yourself a few questions:
- How much risk are you able to accept? This will be determined by your personal financial goals as well as by your individual financial situation.
- Are you able to meet your financial obligations even if this investment goes south? Remember higher yield also means higher risk.
Then, do some due diligence. Learn how these high-yield investments are generating such positive returns and what types of factors will impact stability and cause fluctuation.
It’s important to understand how the investment is positioned among market indicators like:
- Financial operating condition
- Industry standing
- Competitive landscape
- Overall economic conditions
Types of High-Yield Investments
When looking for high-yield investments, you’ll have many options. Which path you choose will ultimately depend on a variety of factors, including your portfolio makeup, your risk tolerance, and the number of years until you retire.
Here are some investment options that are generally considered to be high yield.
High-yield bonds, also referred to as “junk bonds,” are often issued by companies whose financial strength may not be reliable. To attract investors, these bonds pay a higher yield than safer alternatives.
While investing in high-yield individual bonds is an option, most investors opt for high-yield bond mutual funds or exchange-traded funds (ETFs) instead, since they’re likely to offer more diversification.
Corporate Bonds Funds
Corporations often raise money by issuing bonds to investors. They are then packaged into funds that can include bonds from hundreds of corporations.
Corporate bond funds can generate income and minimize risk at the same time. Risk is minimized because the corporate bond funds are diversified among a host of individual securities. Short-term bonds, with average maturity dates between one and five years, are less susceptible to interest rate changes than their intermediate or longer-term counterparts.
However, those short-term corporate bond funds are not FDIC-insured. Plus, you always carry the risk that a company’s credit rating might be downgraded or they might default on the bonds. To minimize your risk, be sure to review bond funds and check to see that they consist of high-quality corporate bonds.
Investment-grade short-term bond funds often earn higher returns than government bonds and municipal bonds. These funds have no liquidity concerns as you can buy or sell shares at any time. Plus, in most cases, you can reinvest income dividends and grow the investment faster that way.
Preferred stocks are considered favorable high-yield investment options by many investors. Holders of preferred stock receive preferential treatment in the payout order of a company’s assets and receive dividend payouts before holders of common stock. Another defining characteristic of preferred stock is that preferred shareholders have no voting rights, while common shareholders do.
The high-yield dividends offered by preferred stocks ensure an extra level of safety since preferred stockholders have priority over common shareholders in receiving payment during tumultuous times.
Dividend-Paying Stocks “On Sale”
Many of today’s investors continue to chase growth while ignoring yield. By overlooking anything from the value side of stock market investing, you could be missing out on significant opportunities.
While it’s always a good idea to seek out stocks that pay handsome dividends, look for those that are also considered value stocks. Doing this is like buying shares “on sale.”
It’s easy for the emotions inside of you to want to jump on the coattails of a stock that’s shooting upward. But those really hot stocks go against the basic rule of investing, which is buy low and sell high.
When you find dividend stocks that are currently “on sale,” not only are you going to buy low and sell high, but you’re also going to earn a high yield while you wait for the stock price to recover and rally.
Mortgage Real Estate Investment Trusts
Real estate in the United States has been among the best performing investments in modern history. But something few people realize is that there are ways to make money in real estate without ever owning property. A mortgage real estate investment trust (REIT) is one of those tools.
So even without loads of capital, it’s now possible to build wealth with real estate at a fraction of what it used to cost.
General REITs — also known as equity REITs — invest in commercial property and then generate income from that property. Mortgage REITs, on the other hand, provide real estate financing. They originate mortgage loans and mortgage-backed securities in order to generate interest income.
So when you invest in a mortgage REIT, you are profiting from the mortgages and mortgage-backed securities that finance the actual real estate. Owners of mortgage REIT shares can also find themselves profiting significantly from high-paying dividends, which is why many investors like this option.
Like all REITs, a mortgage REIT receives favorable tax treatment. In return, the REIT is obligated to distribute 90% of its profits in the form of dividends to its investors.
However, mortgage REITs are riskier than typical equity REITs. Because mortgage REITs borrow more money, they are leveraged to a greater degree and, as a result, are more vulnerable to interest rate risk.
Timing will be a factor when considering mortgage REITs, since in an environment of rising interest rates, mortgage REITs will see diminished returns.
Dive Into High-Yield Investing
Venturing into the area of high-yield investments can feel daunting at first.
Just the very name “high yield” makes this type of investment feel like it’s too good to be true. And many high-yield investments can be too good to be true.
So how can you make the best decision about which high-yield investment options are solid choices?
To learn two critical criteria to look for in high-yield investments, subscribe to the Investors Alley “Dividend Hunter” newsletter.