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The Relationship Between Risk and Yield in the Bond Market

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Why do bonds offer the yields that they do? Throughout 2012, investors got paid less than 2% to own a 10-year U.S. Treasury note, while some high-yield bonds would have paid you 8% or higher. Long-term bonds in Spain yielded over 7% for part of that year, while government bonds in Germany paid next to nothing.

The reason for these difference is that investors need to be paid in order to take risk. If an investment is seen as being low risk (such as Treasuries), investors don't require a huge yield to tie up their cash. But if an investment is seen as being higher-risk, market participants will demand adequate compensation to take the chance that their principal could decline.

Take Italy as an example. In 2012, the country was already burdened with a high level of debt, which caused its bonds to rise to levels that were among the highest in the developed markets. Why? Investors, seeing the country's enormous debt load and weak economy, believed there was a greater risk that it can pay its interest and principal obligations than a healthier country such as Germany. As a result, yields in Italy soared to the 7% range at the same time yields in Germany and the United States. From this example, we see that high risk = high yield, while low risk = low yield. Keep in mind, yields rise when prices fall, and vice versa.

There’s a lesson here for investors: when shopping for an individual bond, a mutual fund or ETF, or even for an entire asset class, never just invest on the basis of yield. Many people are captivated by the allure of high yield bonds, but they miss out on the fact that high yield can also experience sharp price declines. In the final six months of 2008, for instance, the SPDR Barclays Capital High Yield Bond ETF (ticker:JNK) declined an incredible 20.9% -- a rude awakening for anyone who bought the ETF without thinking about the risks.

With all of this said, it’s true that with high risk can also come high reward. When investors are expecting the worst – which is usually reflected in the form of elevated yields – a positive surprise can often lead to outsized returns. Using JNK as an example once again, someone who purchased the ETF at its crisis low on March 9, 2009, and held through the end of the year would have experienced a blistering gain of 67.9%.

This shows that it absolutely can pay handsomely to take on added risk. But – and this is a big but – you have to have the experience to get the timing right and the fortitude to hold on once your winning investment starts rising. This works for many sophisticated investors, but for the rest of us it can be extremely challenging. If you are of a mind to take on added risk in the quest for higher returns, make sure it’s with money you can afford to lose.

The Bottom Line

Investing solely on the basis of yield is one of the worst mistakes an investor can make. Be sure you understand the full picture before you pour cash into an investment with a yield that seems too good to be true. More often than not, you’ll get the opposite of the high return you were expecting.

Learn more about bond basics.

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