High Yield Bonds Explained: Definition and Types

What are High Yield Bonds?

High yield bonds are essentially a form of corporate debt that pays higher returns due to their lower credit ratings. The term "junk bonds" often refers to these high yield bonds because of their increased likelihood to default. The issuers of such bonds usually comprise startup ventures or capital-intensive companies with a high ratio of debt.

Understanding High Yield Bonds

A high yield bond is a debt instrument issued by a company with the promise to pay interest and return the principal at maturity. The "junk" status of these bonds indicates that they are issued by companies with poorer credit quality.

Credit Ratings of High Yield Bonds

Typically, high yield bonds carry lower credit ratings from leading credit agencies. A bond is considered non-investment grade or high yield if it has a rating below BB+ from Standard & Poor’s and Fitch, or Ba1 or below from Moody’s. Bonds with ratings above these levels are considered investment grade.

Subcategories of High Yield Bonds

High yield bonds can be divided into two main subcategories:

• Fallen angels - A bond that has been downgraded by a major rating agency due to the issuing company’s poor credit quality.
• Rising stars - A bond whose rating has increased because of the issuing company’s improving credit quality.

Advantages and Disadvantages of High Yield Bonds

Like any financial instrument, high yield bonds come with their own set of advantages and disadvantages.

Advantages

• Higher returns: High yield bonds offer higher yields than investment-grade bonds if they do not default. The bonds with the highest risks typically offer the highest yields.
• Potential for capital appreciation: If the issuing company's financial performance improves, the price of a high yield bond can significantly increase.

Disadvantages

• Default risk: High yield bonds are more likely to default, which is the most significant risk for investors.
• Higher volatility: Prices of high yield bonds have been historically more volatile than their investment-grade counterparts.
• Interest rate risk: All bonds face the risk that market interest rates will rise and cause the price of a bond to decrease.
• Liquidity risk: High yield bonds generally have higher liquidity risk than investment-grade bonds.

Investment Grade vs Non-Investment Grade

Bonds can typically be classified into investment grade and non-investment grade. 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.

Investing in High Yield Bonds

There are several ways to invest in high yield bonds:

• Buy high yield corporate bonds directly from broker-dealers.
• Buy into a mutual fund or ETF that holds high yield bonds.

The Effect of Rising Interest Rates on High Yield Bonds

When interest rates rise, the market value of high yield bonds can decline. However, rising interest rates can also benefit high yield bonds as interest rates usually increase when the economy expands.

High Yield Bonds and Credit Rating Agencies

Credit rating agencies evaluate bond issuers and assign ratings. Those issuers considered to have a greater risk of defaulting on repayments are rated below investment grade and thus, must pay higher coupons to attract investors.

Evolution of High Yield Bonds Market

The high yield market has evolved significantly over the years. Today, much high yield debt is used for general corporate purposes such as financing capital needs or consolidating and paying down bank lines of credit.

Benefits of Investing in High Yield Bonds

High yield bonds may offer investors a number of potential benefits:

• Diversification: High yield bonds typically have a low correlation to investment-grade fixed income sectors, which means that adding high yield securities to a broad fixed income portfolio may enhance portfolio diversification.
• Enhanced current income: High yield bonds usually offer significantly greater yields than government bonds and many investment grade corporate bonds.
• Capital appreciation: An economic upturn or improved performance at the issuing company can have a significant impact on the price of a high yield bond.

Risks Associated with High Yield Bonds

Compared to investment-grade corporate and sovereign bonds, high yield bonds are more volatile with higher default risk among underlying issuers. In times of economic stress, defaults may spike, making the asset class more sensitive to the economic outlook than other sectors of the bond market.

Summary and Key Takeaways:

High yield bonds, often referred to as junk bonds, are corporate debt securities that offer higher interest rates due to their lower credit ratings, typically issued by startups or highly indebted firms. These bonds carry risks such as default, volatility, interest rate changes, and liquidity concerns, but also offer potential benefits like higher returns, capital appreciation, and diversification for investors. Their attractiveness hinges on the investor's risk tolerance and financial goals. The market for high yield bonds has evolved, becoming a significant part of corporate financing for various purposes.

• Definition and Nature: High yield bonds are lower-rated corporate debt securities that provide higher returns due to increased risk.
• Credit Ratings: These bonds are rated below investment grade by major credit rating agencies.
• Subcategories: Includes 'fallen angels' (downgraded bonds) and 'rising stars' (upgraded bonds).
• Risks: High default risk, volatility, interest rate risk, and liquidity risk.
• Benefits: Offers higher yields, potential for capital appreciation, and portfolio diversification.
• Investment Strategies: Can be invested in directly or through mutual funds and ETFs.
• Market Sensitivity: Sensitive to interest rate changes and overall economic conditions.
• Evolution: The high yield bond market has grown and diversified over time.
• Investor Considerations: Suitable for investors with higher risk tolerance and specific financial goals.