High-yield bonds are debt securities, also known as junk bonds, that are issued by corporations. They can provide a higher yield than investment-grade bonds, but they are also riskier investments.
What Are High-Yield Bonds?
High-yield bonds (also called 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 than investment-grade bonds to compensate investors.
Issuers of high-yield debt tend to be startup companies or capital-intensive firms with high debt ratios. However, some high-yield bonds are fallen angels, which are bonds that lost their good credit ratings.
Key Takeaways
- High-yield bonds, or junk bonds, are corporate debt securities that pay higher interest rates than investment-grade bonds.
- High-yield bonds tend to have lower credit ratings of below BBB- from Standard & Poor’s and Fitch, or below Baa3 from Moody’s.
- Junk bonds are more likely to default and have higher price volatility.
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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. Junk bonds are issued by companies with poorer credit quality.
Bonds are characterized by their credit quality and fall into one of two bond categories: investment grade and non-investment grade. Non-investment-grade bonds, or high-yield bonds, carry lower credit ratings from the leading credit agencies.
A bond is considered non-investment grade if it has a rating below BB+ from and Fitch, or Ba1 or below from Moody’s. Bonds with ratings above these levels are considered investment grade. Credit ratings can be as low as D (in default), and most bonds with C ratings or lower carry a high risk of default.
High-yield bonds are typically broken down into two subcategories:
- Fallen angels—A bond that has been downgraded by a major rating agency and is headed toward junk-bond status because of the issuing company’s poor credit quality.
- Rising stars—A bond with a rating that has increased because of the issuing company’s improving credit quality. A rising star may still be a junk bond, but it’s headed toward being investment quality.
Advantages of High-Yield Bonds
Investors choose high-yield bonds for their potential for higher returns.
High-yield bonds do provide higher yields than investment-grade bonds if they do not default. Typically, the bonds with the highest risks also have the highest yields. Modern portfolio theory states that investors must be compensated for higher risk with higher expected returns.
Disadvantages of High-Yield Bonds
While high-yield bonds do offer the potential for more gains compared to investment-grade bonds, they also carry a number of risks, like default risk, higher volatility, interest rate risk, and liquidity risk.
Default Risk
Default is itself the most significant risk for high-yield bond investors. The primary way of dealing with default risk is diversification, but that limits strategies and increases fees for investors.
With investment-grade bonds, you can buy bonds issued by individual companies or governments and hold them directly. When you hold individual bonds, you can build bond ladders to reduce interest rate risk. Investors can often avoid the fees related to funds by holding individual bonds. However, the possibility of default makes individual bonds riskier than investing in bond funds.
Small investors may want to avoid buying individual high-yield bonds directly because of high default risk. High-yield bond exchange-traded funds (ETFs) and mutual funds are usually better choices for retail investors interested in this asset class because their diversity helps reduce risk.
Higher Volatility
Historically, high-yield bond prices have been significantly more volatile than their investment-grade counterparts. The volatility of the high-yield bond market is similar to the volatility of the stock market, unlike the investment-grade bond market, which has much lower volatility.
Interest Rate Risk
All bonds face interest rate risk. This is the risk that market interest rates will rise and cause the price of a bond to decrease. The price of bonds move in the opposite direction of the price of market interest rates.
The longer a bond’s term, the higher the interest rate risk because there is more time for interest rates to change.
Liquidity Risk
Liquid assets are ones that you can sell easily for cash. When bonds are traded frequently, they have higher liquidity. Liquidity risk is the risk that you won’t be able to sell an asset at the time and for the price that reflects the true value of the bonds.
High-yield bonds generally have higher liquidity risk than investment-grade bonds. Even high-yield bond mutual funds and exchange-traded funds (ETFs) carry liquidity risk.
Investment Grade vs. Non-Investment Grade
You can typically classify bonds into investment grade and non-investment grade. Bonds are rated by three major ratings agencies: Moody’s, Standard & Poor’s, and Fitch.
When a bond is rated Baa3 or higher by Moody’s or BBB- or higher by Standard & Poor’s or Fitch, it is considered investment grade. Bonds rated Ba1 or lower by Moody’s or BB+ or lower by Standard & Poor’s or Fitch are considered non-investment grade.
You’ll want to have a higher risk tolerance for investing in non-investment-grade bonds.
How to Invest in High-Yield Bonds
You can invest in high-yield bonds in several ways:
- You can buy high-yield corporate bonds directly from broker-dealers.
- You can buy into a mutual fund or ETF that holds high-yield bonds.
With the latter strategy, you buy shares of a fund that is managed by a fund manager who chooses which bonds to include.
When researching your choices in high-yield bonds, you can read primary documents like the bond’s prospectus, which provides information about the financial health of the company issuing the bond. It also includes the company’s plans for using the proceeds of the bond, along with the bond terms and risks involved.
The Effect on High-Yield Bonds When Interest Rates Rise
When interest rates rise, the market value of high-yield bonds can decline because investors can get higher returns with newer bonds.
However, rising interest rates can also help high-yield bonds because interest rates tend to increase when the economy expands, so the corporations issuing the bonds can benefit from increased spending. This means that these bonds would have a lower risk of default.
What is a non-investment-grade bond?
A non-investment-grade bond is a bond that pays higher yields but also carries more risk and a lower credit rating than an investment-grade bond. Non-investment-grade bonds are also called high-yield bonds or junk bonds.
Are BBB bonds investment grade?
Bonds that have a BBB rating from either Standard & Poor’s or Fitch are considered investment-grade bonds, although they are the lowest tiers of investment-grade bonds. Non-investment-grade bonds are rated BB+ through CC. (Moody’s uses a different rating system.)
The Bottom Line
Like with any investment, high-yield bonds have risks and rewards to consider. For investors with a high risk tolerance, high-yield bonds may fit their investing goals. These bonds can offer more attractive yields, but they carry more risk and a lower credit rating than investment-grade bonds.
Factor in your individual financial situation, including your income, net worth, investment goals, and risk tolerance, when deciding whether high-yield bonds are right for you.
