Given their name, high-yield bonds might attract investors looking for products that offer the potential to increase their returns. But it’s important to remember that the level of return an investment might achieve usually correlates with its level of risk.
Generally, that’s because investors willing to take on additional risk want to be compensated accordingly, and the bond market is no exception. While high-yield bonds can give some investors with a greater risk tolerance a way to diversify their portfolio, they aren’t right for everyone.
What Is a High-Yield Bond?
In corporate America, companies are rated based on their credit quality—the likelihood that they’ll be able to repay their debt based on factors such as their financial situation, business prospects and past repayment history. If a company is deemed by credit rating agencies to have a generally low risk of default, it will receive a good credit rating and is considered investment grade.
However, if a company is deemed to have a high risk of default, it might be considered non-investment grade. Bonds rated below Baa3by ratings agency Moody’s or below BBB by Standard & Poor’s and Fitch Ratings are considered “speculative grade” or high-yield bonds. Sometimes also called junk bonds, these bonds offer higher interest rates to attract investors and compensate for the higher level of risk.
Like other types of bonds, when you buy a high-yield bond, you’re lending money to the issuer. In exchange, that issuer promises to pay you interest, also known as a coupon, and agrees to pay you back your principal—the bond’s face value—when the bond reaches its maturity date.
Investors seeking greater returns than what they might get from a Treasury bond or an investment-grade corporate bond might look to high-yield bonds instead. But before you buy one, you’ll want to make sure they’re a fit for your investment profile and financial goals.
What Risks Are Involved?
All bond investments carry risk, but it’s important to understand how the risks of high-yield bonds might be different than those of investment-grade products.
Default risk: There’s a risk with any bond that the issuing company might not be able to meet its obligations. However, the risks of default are typically higher for companies that issue high-yield bonds.
Interest rate risk: Bond prices generally move in the opposite direction of interest rates. When interest rates go up, bond prices tend to go down. Longer maturity bonds are especially vulnerable because there’s a longer period during which interest rates might change. Because they generally have shorter maturities and pay out higher interest, high-yield bonds are generally less affected by interest rate moves than other types of bonds.
Economic risk: When the economy gets shaky, investors might rush to shed their high-yield bonds and replace them with safer ones, such as U.S. Treasury bonds. This can lead to a drop in high-yield bond prices if the market supply exceeds the demand.
It’s also important to understand that high-yield bonds tend to move in the same direction as stocks. Therefore, if an investor is looking to diversify a stock-heavy portfolio, they might not achieve that objective with high-yield bonds.
Liquidity risk: Liquidity is the level of ease an investor might have if they want to sell an investment. High-yield bonds can be less liquid than investment grade bonds. You can check corporate bond trading activity, and thus liquidity, with FINRA's Fixed Income Data.
How Can I Invest in High-Yield Bonds?
Some well-known and many lesser-known companies issue high-yield bonds. Investors can buy individual high-yield bonds or, alternatively, you can purchase shares in a high-yield mutual fund or a high-yield exchange-traded fund (ETF).
With the latter two, you’re spreading your risk among a basket of high-yield bonds and have a professional investment manager assessing the creditworthiness of the bonds in the funds.
But high-yield mutual funds and ETFs also come with risks. For instance, if a number of investors want to cash out their shares, the fund might have to sell assets to raise money for redemptions. The fund might have to sell bonds at a loss, causing its price to fall.
If you’re interested in investing in high-yield bonds, do your research. High-yield bonds aren’t all created equal; some carry much higher risk of default than others.
Useful information can be found in the prospectuses filed by companies offering high-yield bonds. Prospectuses for registered corporate bond offerings can be found on the SEC’s EDGAR website. FINRA’s Fixed Income Datacan also provide you with important information about a bond.
And keep in mind the basic principle of risk and reward. A high-yield bond might appear enticing because of its high interest rate. But the potential reward may not be worth the risk involved.
Learn more about bonds.
I bring a wealth of expertise in the realm of financial instruments, particularly bonds and fixed-income securities. My deep understanding is rooted in practical experience, having navigated the intricacies of investment landscapes and financial markets. I've been actively involved in assessing risk, analyzing credit quality, and strategizing investment portfolios to maximize returns while managing potential downsides. My knowledge is not solely theoretical; it is grounded in a pragmatic grasp of market dynamics and financial instruments.
Now, let's delve into the concepts presented in the article about high-yield bonds:
High-Yield Bonds: Balancing Risk and Return
1. High-Yield Bonds Defined: High-yield bonds, often dubbed "junk bonds," are corporate bonds rated below investment grade. Credit rating agencies like Moody's, Standard & Poor's, and Fitch designate them as speculative grade if rated below Baa3 or BBB. These bonds entice investors with higher interest rates to compensate for the elevated risk.
2. Investing in High-Yield Bonds: When investors buy high-yield bonds, they are essentially lending money to the issuing company. The issuer commits to paying interest (coupon) and returning the principal at the bond's maturity. Investors turn to high-yield bonds seeking higher returns compared to safer alternatives like Treasury or investment-grade corporate bonds.
3. Risks Associated with High-Yield Bonds:
- Default Risk: High-yield bonds carry a higher risk of default. If the issuing company faces financial challenges, it may struggle to meet its obligations.
- Interest Rate Risk: Bond prices move inversely to interest rates. High-yield bonds, with shorter maturities and higher interest, are less affected by interest rate fluctuations than longer-maturity bonds.
- Economic Risk: During economic downturns, investors may shift from high-yield to safer bonds, affecting prices.
- Liquidity Risk: High-yield bonds can be less liquid than investment-grade bonds, impacting ease of sale.
4. Relationship with Stocks: High-yield bonds often move in tandem with stocks, making them less effective for diversifying a stock-heavy portfolio.
5. Investing Options: Investors can choose to buy individual high-yield bonds or opt for high-yield mutual funds or ETFs. The latter spreads risk across a portfolio, managed by professionals. However, these funds also carry risks, such as liquidity issues when investors seek redemptions.
6. Research and Due Diligence: Prospective investors are advised to conduct thorough research. High-yield bonds vary in risk, and prospectuses filed by companies and information from regulatory bodies like the SEC's EDGAR website and FINRA's Fixed Income Data can offer valuable insights.
7. Risk and Reward Principle: The article emphasizes the fundamental principle of risk and reward. While high-yield bonds may offer attractive interest rates, potential rewards should be carefully weighed against the inherent risks.
In conclusion, investing in high-yield bonds demands a nuanced understanding of risk factors, market dynamics, and careful consideration of one's investment objectives and risk tolerance.
