High-yield bonds: what they are, how they work and the risks

Tendersetter

10:49 am

7 May 2020

What are high-yield bonds?

They are a type of corporate bond that pays a higher interest rate due to its higher default risk. When companies presenting high default risk issue bonds, they might not be able to obtain a high enough credit rating. Consequently, they usually issue bonds with higher interest rates to attract investors and compensate them for this higher risk.

Issuers of high-yield bonds might be deeply indebted companies or companies that have a troubled financial history. Even the smallest or emerging companies can issue high-yield bonds, since their financial plans can be considered speculative or risky.

High-yield bonds have the lowest credit ratings from the main rating agencies: they are usually rated below “BBB-” (S&P) or “Baa3” (Moody’s). Bonds at or above these ratings are considered investment grade. The lowest possible credit rating is a “D” (default) and most bonds with a rating of “C” or a lower rating carry a high risk of default.

The advantages of high-yield bonds

Higher returns

Theoretically, high-yield bondholders can expect additional returns of 150 to 300 basis points compared to what they would earn on investment-grade bonds at any given time. However, in practice, the returns could be lower due to the higher default risk. Mutual funds and exchange-traded funds (ETFs) are other ways of earning higher returns without the risk of investing in the junk bonds of one issuer only.

The risks of high-yield bonds

Default risk

The default risk of high-yield bonds is higher because their issuers are companies with high financial risks. Default occurs when the issuing company is no longer able to pay interest or principal payments on time or when it does not comply with the terms of the agreements reached at the time of the sale.

More volatility

Historically, high-yield bond prices have been more volatile than their investment-grade counterparts. Overall, high-yield bond volatility is more similar to that of the equity market than it is to the investment-grade bond market’s volatility.

How to invest in high-yield bonds

You can invest directly in high-yield corporate bonds by buying them from brokers. Otherwise, you can buy units of mutual funds or ETFs specialised in high-yield bonds. These funds have securities portfolios containing high-yield bonds selected directly by the fund manager. It is important to evaluate this type of investment with professionals in advance in order to fully understand their risks and characteristics.

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