risk
Don't reach for yield
The rule
A weak company's bond pays extra interest for a reason. The extra rarely covers the higher chance you never get paid back.
Where it flips
But fearing all yield can leave you in cash that inflation slowly eats. The fix is to take sensible, well-covered income risk, not to reach into fragile borrowers for a flashy rate.
A higher interest rate is not a gift. It is the market's price for a higher chance you will not be repaid. Chasing a few extra percent into shaky borrowers trades a small, sure bit of income for a large, sometimes total, loss of your money. That is a bad deal for money you need to stay safe.
A worked example
A shaky company's bond offers 14%, while a strong company's offers 7%. Aayra takes the strong 7%. Over many such choices, the defaults among the 14% bonds wipe out the extra income and then some. [illustrative]
How to spot it
- ·picking a bond mainly for its high rate
- ·weak profit behind the promised payment
- ·the extra rate not weighed against default risk
Benjamin Graham · The Intelligent Investor