High-Yield Bond: Definition, Types, and How to Invest

What Are High-Yield Bonds?

High-yield bonds, often referred to as junk bonds, are debt securities issued by corporations that offer higher interest rates due to their lower credit ratings compared to investment-grade bonds. While they have the potential to provide attractive yields, these bonds also involve greater risks, including a higher likelihood of default. Typically, high-yield bonds are issued by startups or capital-intensive firms with substantial debt ratios. Some high-yield bonds are known as "fallen angels," as they once held higher credit ratings before being downgraded.

Deep Dive into 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 non-investment grade if its rating is below BB+ by Standard & Poor’s 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.

Benefits of Choosing High-Yield Bonds

Investors choose high-yield bonds for their potential for higher returns. High-yield bonds offer higher returns than investment-grade bonds, unless they default. Typically, the riskier the bond, the higher the yield. Modern portfolio theory states that investors must be compensated for higher risk with higher expected returns.

Risks and Downsides of High-Yield Bonds

High-yield bonds can lead to higher gains than investment-grade bonds, but they also come with risks like default, volatility, interest rates, and liquidity issues.

Understanding 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 directly from companies or governments and hold them. Holding individual bonds lets you build bond ladders to manage 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.

Navigating High 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.

Managing Interest Rate Risk

All bonds face interest rate risk. This is the risk that market interest rates will rise and cause the prices of a bond to decrease. The price of bonds move in the opposite direction to 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.

Tackling 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.

Comparing Investment-Grade with Non-Investment-Grade Bonds

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.

Investing in High-Yield Bonds: A Comprehensive Guide

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 go up, high-yield bond values can drop since newer bonds offer better returns. 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.

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.