High-Yield Bonds

investing
May 4, 2020

A high-yield bond, also called junk bond or non-investment grade bond, is a bond that is rated below investment grade, because the poor creditworthiness of the issuer.

Companies and governments issue bonds as a way to borrow money and raise capital for funding their operations. When an investor buys a bond, he is lending money to the issuer in exchange for regular interest payments and the return of the invested money on the maturity date. To attract investors, high-yield bonds pay a higher interest than investment grade bonds.

Companies or governments who issue junk bonds are not in good financial standing and have a high risk of not being able to make their interest payments and repay their loans. Investors can find out about the credit worthiness of bond issuers either by making an assessment on their own of the company's financials, or by checking the credit rating of the bond.

Who issues junk bonds?

Companies and governments issue bonds to fund capital-intensive projects. Rising stars, or emerging companies, do not have the the same financial security as investment grade companies, and are typically given low ratings. In addition, sometimes investment grade companies run into financial troubles and get downgraded to junk bond status. These companies are referred to as "fallen angels." For example, Ford has been downgraded to junk bond status during the corona virus crises.

High yield bond market as indicator of investor sentiment

An increase in demand for high yield bonds means that investors are willing to take on more risk. This can indicate an improved market sentiment. On the other hand, when the demand for high yield bonds decreases, this usually means that investors are becoming more risk averse and prefer safer investments instead.

How to invest in high yield bonds?

You can either buy single high yield bonds, or buy shares of a high yield bond exchange traded funds (ETFs) or mutual funds. Mutual funds and ETFs provide are single investment vehicles that hold a diverse basket of bonds. ETFs and mutual funds provide easy diversification and make investing less risky than buying only a single bond.

Characteristics of high yield bonds

High yield bonds are characterized by a poor credit rating. Credit rating agencies assess the creditworthiness of all corporate and government bonds based on the issuer's financial security and ability to pay back debt. There are different letter grades for credit ratings. Junk bonds are rated below BBB- by Standard & Poor's.

Since high yield bonds are riskier than investment grade bonds, investors need to be offered a higher interest rate to compensate for the risk and create an incentive to invest in high yield bonds. The lower the credit rating of the bond, the higher the interest they pay. Junk bonds may offer interest 150 to 1500 basis points (1.5% to 15%) higher than high quality bonds.

High yield bonds are more volatile investments than investment grade bonds, but are still less volatile than equities (stocks).

How do high yield bonds compare to investment grade bonds?

Here is a chart comparing the total return of a high yield bond ETF to an investment grade bonds ETF in 2020. ETFs hold a diverse variety of assets and by comparing them we can get a sense of the overall relative performance of the two markets. The high yield bonds took a bigger hit than investment grade bonds when markets went sour during the COVID-19 crisis. You would have experienced a dip of about 20% if you had invested the high yeild ETF at the start of 2020, and it would have taken until August for your investment to recover. Investment grade bonds faired much better, on the other hand, especially with regards to the recovery time, and outperformed junk bonds by around 5% in the year.

Junk bonds vs investment grade bonds performance, 2020

Next, let's compare the total return over a longer time horizon in the plot below. There are definitely periods when junk bonds outperformed investment grade bonds. However, they are prone to big declines during recessions and economic slowdowns. By the end of 2020, the total return on investment is roughly the same for the two, but the high yield bonds hand a lot more ups and downs.

Junk bonds vs investment grade bonds performance, long term

Looking at the performance of high yield bond ETFs, it might seem like an allocation to high yield bonds might not improve a traditional balanced portfolio. There are many investment professionals who avoid junk bonds. On the other hand, investors with deep knowledge and expertise can find opportunities after analyzing in depth.

How do high yield bonds compare to stocks?

Equities offer higher return at a higher level of risk than high yield bonds. Here is a chart comparing the total return of the high yield ETF with the stock market S&P 500. The worst drawdown of both returns occurred during the coronavirus recession. The S&P 500 dropped by about 34%, while high yield bonds dropped by 20%. By the end of the investment period, the return is roughly four times higher with stocks.

Junk bonds vs stocks performance, long term

Special risks with high yield bonds

Default risk

The most significant risk when lending money to a company with poor credit rating is that the company might default on its loans. There is no guarantee that you will get back your money, and the risk gets higher with lower credit ratings. To assess the risk of default you can either conduct your own credit analysis of the bond issuer, or you can simply check the ratings of credit rating agencies.

In case of default, bondholders are first in line to get paid out during the liquidation of assets, and stock holders receive whatever is left.

The best way to mitigate default risk is through diversification, i.e. by not putting all the eggs in one basket. You can easily attain diversification if investing via ETFs or mutual funds. Otherwise, it is also possible to build a diverse portfolio by buying individual high yield bonds.

Call risk

High yield bonds are often callable. This means that the issuer can refinance the loan to take advantage of better interest rates. For example, if you buy a high yield bond with a BB+ rating, and then the bond rating is upgraded to BBB-, then the issuer will be able to obtain financing for a lower interest rate and can opt to call its outstanding bonds that it issued when the rating was BB+.

Interest rate risk

The interest rates of high yield bonds change over time depending on the market conditions and the credit rating of the issuers. If you buy a bond and then later the interest rate increases, your bond holding will be paying less interest than new bond issues. The market value of your bond is less than your investment if you decide to sell before maturity.

Downgrade risk

The credit rating of a junk bond issuer can worsen as the company runs into financial difficulties. When this occurs, the market value of the bond reduces. The issuer might also need to issue more bonds at a higher interest rate, which leads to further loss on your investment.

Price Volatility

High yield bonds experience much larger price swings than investment grade bonds. This is due to several factors, including uncertainties surrounding the issuer's financial security, interest rates, as well as the market supply and demand.

Takeaways

  • High yield bonds, or junk bonds, are bonds issued by companies or governments with poor credit ratings. These bonds are riskier, and therefore offer higher interest rates.
  • There are various risks when investing in high yield bonds, including the risk of default. It is important to ensure that your portfolio is adequately diversified if you invest in high yield bonds.
  • You can invest in high yield bonds either by buying individual bonds, or via ETFs and mutual funds.
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