What Are High-Yield Corporate Bonds?

What is a high-yield corporate bond?

A high-yield corporate bond (or junk bonds) is a form of corporate bond that because of

its greater probability of default, provides a higher rate of interest. They will be unable to receive

an investment-grade bond credit rating when companies with a higher estimated default risk

issue bonds. As a result, bonds with higher interest rates are usually sold to entice buyers and

compensate them for this higher risk.

The issuers of high-yield bonds may be companies characterized as heavily leveraged or

financially troubled. High-yield bonds may also have to be issued by smaller or developing

companies to cover unproven operating histories or because their financial plans may be deemed

speculative or risky.

More About High-Yield Bonds

From a technical viewpoint, a high-yield, or "junk" bond is pretty much the same as

regular corporate bonds since they both represent debt issued by a firm with the promise to pay

interest and return the principal at maturity. Junk bonds differ because of their issuers' poorer

credit quality.

All bonds are characterized according to this credit quality and therefore fall into one of

two bond categories: high-yield and investment grade.

  Investment Grade – These bonds are issued by low- to medium-risk lenders. A

bond rating on investment-grade debt usually ranges from AAA to BBB.

Investment-grade bonds might not offer huge returns, but the risk of the borrower

defaulting on interest payments is much smaller.

 Junk Bonds – These are the bonds that pay high yield to bondholders because the

borrowers don't have any other option. Their credit ratings are less than pristine,

making it difficult for them to acquire capital at an inexpensive cost. Junk bonds

are typically rated 'BB' or lower by Standard & Poor's and 'Ba' or lower by

Moody's.

Example

High-yield bonds carry lower credit ratings from the leading credit agencies. A bond is

considered speculative and will thus have a higher yield if it has a rating below "BBB-" from

S&P or below "Baa3" from Moody's. Bonds with ratings at or above these levels are considered
investment grade. Credit ratings can be as low as "D" (currently 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 sub-categories:

 Fallen Angels: This is a bond that was once investment grade but has since been reduced

to junk-bond status because of the issuing company's poor credit quality.

 Rising Stars: The opposite of a fallen angel, this is a bond with a rating that has been

increased because of the issuing company's improving credit quality. A rising star may

still be a junk bond, but it's on its way to being investment quality.

Advantages of High-Yield Bonds

Higher Yields

Generally, investors in high-yield bonds can expect at least 150 to 300 basis points in

additional yield compared to investment-grade bonds at any given time. In actual practice, the

gain over investment-grade bonds is lower because there will be more defaults. Mutual funds and

exchange traded funds (ETFs) provide ways to tap into these higher yields without the undue risk

of investing in just one issuer's junk bonds.

Higher Expected Returns

While high-yield bonds suffer from the negative "junk bond" image, they actually have

higher returns than investment-grade bonds over most long holding periods. For example, the
iShares iBoxx $ High Yield Corporate Bond ETF (HYG) had an average annual total return of

6.44% between the beginning of 2010 and the end of 2019.

During that time, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)

returned an average of 5.93% per year. This result is in accord with modern portfolio theory

(MPT), which holds that investors must be compensated for higher risk with higher expected

returns.

Disadvantages of High-Yield Bonds

There are several negative aspects of high-yield corporate bonds that investors must consider as

well to make a shrewd investment:

1. Higher default rates. There’s no way around this, the only reason high-yield bonds are

high-yield is because they carry with them a greater chance of default than traditional

investment-grade bonds. Since a default means the company’s bonds are worthless, this

makes such investments far more risky to include in a portfolio of traditional bonds.

However, it should be noted that when a company defaults, they payout bonds before

stocks during liquidation, so bondholders still have greater security than stock market

investors. When mitigating risk is the primary concern, high-yield corporate bonds

should be avoided.

2. They are not as fluid as investment-grade bonds. As a result of the traditional stigma

attached to “junk bonds,” many investors are hesitant to invest in such bonds. This means

that reselling a high-yield bond can be more difficult than a traditional investment-grade
 bond. For investors who want to ensure they have the freedom to resell their bonds, high-

yield corporate bonds are not as attractive.

3. The value/price of a high-yield corporate bond can be affected by a drop in the

issuer’s credit rating. This is true of traditional bonds as well, but high-yield are far

more often affected by such changes (migration risk). If the credit rating goes down

further, the price of the bond can go down as well, which can drastically reduce the ROI.

4. The value/price of a high-yield corporate bond is also affected by changes in the

interest rate. Changes in interest rates can affect all bonds, not just high-yield bonds. If

the interest rate increases, the value of the bond will decrease. If it falls, the value

conversely goes up, so this is a two-way street, there just is a much greater chance of this

going the wrong way with a high-yield bond over a traditional investment-grade bond.

5. High-yield corporate bonds are the first to go during a recession. Traditionally, the

junk bond market has been hit very hard by recessions. Though other bonds may see their

value go up as a way to attract such investors at these times, those who were already

issuing high-yield bonds can’t do this and often begin to fail as other bond opportunities

become more attractive to investors. This means that during a recession almost all junk

bonds, unless they are in recession-resistant industries, run a much higher risk than

normal of becoming worthless.

Who Buys Junk Bonds?

You need to know a few things before you run out and tell your broker to buy all the junk

bonds he can find. The obvious caveat is that junk bonds are high risk. With this bond type, you

risk the chance that you will never get your money back. Secondly, investing in junk bonds

requires a high degree of analytical skills, particularly knowledge of specialized credit. Short and
sweet, investing directly in junk is mainly for rich and motivated individuals. This market is

overwhelmingly dominated by institutional investors.

This isn't to say that junk-bond investing is strictly for the wealthy. For many individual

investors, using a high-yield bond fund makes a lot of sense. Not only do these funds allow you

to take advantage of professionals who spend their entire day researching junk bonds, but these

funds also lower your risk by diversifying your investments across different asset types. One

important note: know how long you can commit your cash before you decide to buy a junk fund.

Many junk bond funds do not allow investors to cash out for one to two years.

Also, there comes a point in time when the rewards of junk bonds don't justify the risks.

Any individual investor can determine this by looking at the yield spread between junk bonds

and U.S. Treasuries. As we already mentioned, the yield on junk is historically 4% to 6% above

Treasuries. If you notice the yield spread shrinking below 4%, then it probably isn't the best time

to invest in junk bonds. Another thing to look for is the default rate on junk bonds. An easy way

to track this is by checking the Moody's website.

The final warning is that junk bonds are not much different than equities in that they

follow boom and bust cycles. In the early 1990s, many bond funds earned upwards of 30%

annual returns, but a flood of defaults can cause these funds to produce stunning negative

returns.

Frequently Asked Questions (FAQs)

Q: Is tthe return provided by the investment fixed or variable?

A: High-yield bonds are corporate bonds, therefore the returns are fixed.

Q: Who is the issuer of the investment?

A: Issuers of High-yield bonds are characterized as heavily leveraged or financially troubled.

They are also issued by smaller or developing companies to cover unproven operating histories

or because their financial plans may be deemed speculative or risky.

Q: Can the investment be liquidated immediately at a known price?

A: No, High-yield bonds cannot be liquidated immediately at a known price?

Q: How long is the term to maturity of the investment?

A: Short-term bonds tend to have low risk and low yields, while longer-term bonds typically

offer higher yields but also greater risk. High-yield bonds often have relatively low duration is

that they tend to have shorter maturities; they are typically issued with terms of 10 years or less

and are often callable after four or five years.

Q: What are the risks faced by the investor in this type of investment?

A: Holders of High-yield bonds face risks such as higher default rates, less fluid bonds, the

value/price of a high-yield corporate bond can be affected by a drop of the company’s credit

rating and changes in interest rate. High-yield corporate bonds are also the first to go during a

recession.