What Are High-Yield Bonds?
High-yield bonds, also known as junk bonds, are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they pay a higher yield to compensate investors.
Issuers of high-yield bonds tend to be startup companies or capital-intensive firms with high debt ratios. Some high-yield bonds are fallen angels, which are bonds that lost their good credit ratings.
Key Takeaways
- High-yield bonds are corporate debt securities that pay higher interest rates than investment-grade bonds.
- They have lower credit ratings, typically below BBB- from Standard & Poor’s and Fitch, or below Baa3 from Moody’s.
- These bonds have higher price volatility and a higher likelihood of default.
Understanding High-Yield Bonds
A high-yield bond, or junk bond, is a corporate bond that represents debt issued by a firm with the promise to pay interest and return the principal at maturity. Typically, these bonds are issued by companies with lower credit quality.
Bonds are characterized by their credit quality and usually fall into investment grade or non-investment grade categories. Non-investment-grade bonds carry lower credit ratings from leading credit agencies.
A bond is non-investment grade if it has a rating below BB+ from Standard & Poor’s and Fitch, or Ba1 or below from Moody’s. Credit ratings can be as low as D (in default). Bonds with C ratings or lower have a high risk of default.
Subcategories of High-Yield Bonds
-
Fallen Angels — Bonds downgraded by rating agencies due to deteriorating credit quality.
-
Rising Stars — Bonds with improving credit quality that may eventually become investment grade.
Advantages of High-Yield Bonds
Investors seek high-yield bonds for potential higher returns. These bonds offer higher yields if they do not default. The higher the risk, the higher the potential returns, in line with modern portfolio theory.
Disadvantages of High-Yield Bonds
Default Risk
Default risk is the most significant concern. Diversification can mitigate this risk, but this strategy may limit opportunities and increase fees. Small investors might prefer high-yield bond exchange-traded funds (ETFs) and mutual funds to reduce risk.
Higher Volatility
High-yield bond prices have historically been more volatile than investment-grade bonds, often mimicking stock market volatility.
Interest Rate Risk
All bonds face interest rate risk—the risk that rising market rates will decrease bond prices. Longer-term bonds face higher interest rate risk.
Liquidity Risk
High-yield bonds generally have higher liquidity risk. Even high-yield bond funds carry this risk. Liquid assets are easier to sell for cash, but high-yield bonds might not be as easily liquidated.
Investment Grade vs. Non-Investment Grade
Bonds are rated by Moody’s, Standard & Poor’s, and Fitch. Bonds rated Baa3 or higher by Moody’s or BBB- or higher by Standard & Poor’s or Fitch are classified as investment grade. Non-investment-grade bonds are riskier and have lower ratings.
How to Invest in High-Yield Bonds
You can invest in high-yield bonds by directly buying them from broker-dealers or by investing in mutual funds or ETFs managed by fund managers. Researching each bond’s prospectus is essential for understanding its financial health, terms, and risks.
Effect of Rising Interest Rates on High-Yield Bonds
When interest rates rise, high-yield bonds’ market value can decline as newer bonds offer better returns. However, rising rates can also benefit the economy, reducing the risk of default for high-yield bond issuers.
FAQ
What is a non-investment-grade bond?
A non-investment-grade bond pays higher yields but carries more risk and a lower credit rating compared to an investment-grade bond. These are also known as high-yield or junk bonds.
Are BBB bonds investment grade?
Yes, bonds rated BBB by Standard & Poor’s or Fitch are considered investment grade. They are at the lowest tier of investment-grade bonds. Non-investment-grade bonds range from BB+ to CC ratings.
Conclusion
High-yield bonds have their own set of risks and rewards. For investors with a high risk tolerance, these bonds might align with their investment goals. They can offer attractive yields but come with more risks. Always assess your financial situation, income, net worth, and risk tolerance before diving into high-yield bonds.
Related Terms: yield, fallen angels, risk tolerance, investment grade.
References
- Investor.gov, U.S. Securities and Exchange Commission. “High-Yield Bond (or Junk Bond)”.
- Fidelity Investments. “Bond Ratings”.
- Vanguard, Institutional Investors. “Crossovers, Fallen Angels, and Rising Stars”.
- U.S. Securities and Exchange Commission. “What Are High-Yield Corporate Bonds?”
- AllianceBernstein. “Rising Rates: Good or Bad for High Yield?”
