What Are High-Yield Bonds?
High yield bonds, also called junk bonds, promise high returns but come with a high risk. They offer higher interest rates than investment-grade corporate bonds and are provided by businesses with lower credit ratings.
High-yield corporate bonds are released into the secondary market to attract investors with a high-risk tolerance. Companies that require urgent financing but can’t get any from any lending institution use high-yield bonds to raise money from the stock market.
A high-yield bond promises higher yields but is much more prone to default risk. Investing in high-yield bonds comes with significant risk, and investors generally possess a secure financial situation.
Understanding High-Yield Bonds
High-yield bonds promise greater returns due to more significant interest payments. However, as their issuers possess lower credit ratings, the probability of incurring credit risk is much greater than investment-grade bonds.
A high-yield bond behaves just like any other corporate bond. The risk arises because issuers of these kinds of bonds have a lower credit rating. One can never be sure of receiving a higher yield from a junk bond as you may never know if the issuer will be able to pay interest or even the principal.
All high-yield bonds can be divided into two categories:
- Fallen Angels: Fallen angels are bonds whose credit rating has been lowered by credit rating agencies. Their status is deprecated due to the lowering of the credit quality of their issuer. Investments in fallen angel high-yield bonds tend to be riskier and are issued by former investment-grade companies.
- Rising Stars: Rising star high-yield bonds are issued by up & coming businesses. Generally issued by startups, they may be currently junk grade due to lower credit ratings of their issuer but are well on their way to becoming investment grade bonds.
Advantages of High-Yield Bonds
The most significant advantage of high-yield corporate bonds is their high-interest rates. Investors are in high-yield bonds due to their higher returns. If one is lucky enough, the issuer won’t default and can return the high-yield debt.
As per Harry Markowitz’s Modern Portfolio Theory or mean-variance analysis, the higher risk associated with a high-yield bond needs to be compensated by higher returns.
Disadvantages of High-Yield Bonds
The risks associated with high yield bonds are many and myriad. That’s why they are referred to as junk bonds. The most prominent risks of non-investment grade bonds are:
- Default Risk: Either rising stars or fallen angels issue non-investment grade bonds. Neither of such companies has impeccable credit quality or repayment capabilities. Thus, there’s a high default risk with these kinds of bonds. A great way for retail or individual investors to reduce the risk associated with junk bonds is to diversify their investment portfolio.
- Higher Volatility: The interest rates of high-yield bond market are much more volatile than investment grade bond market interest rates. Any economic downturn can affect the coupon rate and the face value of junk bonds.
- Interest Rate Risk: Both high-yield bonds and investment-grade bonds carry interest rate risk. The interest rate or coupon rate is permanently fixed, and if the market interest rates increase, corporate bond prices fall. This is because investors of fixed-income securities will no longer buy a corporate bond that offers low returns. Bonds with extended maturity periods also possess higher interest rate risk and higher inflation risk.
- Liquidity Risk: Liquidity risk arises if an investor cannot sell a bond for its actual value. Higher yield bonds possess higher liquidity risks than investment grade bonds.
Investment Grade vs Non-Investment Grade
If you have the money and a proper financial plan, investing in AAA bonds is an excellent fixed-income investment. All bonds can be classified into investment-grade bonds and non-investment-grade bonds, or junk bonds. Top investment grade bonds with AAA credit ratings in India are Tata Income Fund Direct-Growth and ICICI Prudential Long-Term Bond Fund Direct-Plan-Growth.
However, if you want to invest in non-investment grade bonds, then make sure you have a high risk tolerance.
What is a Non-Investment Grade Bond?
A non-investment grade bond is a bond that a company issues with a less-than-stellar credit rating and unreliable creditworthiness. They come with greater default risk and higher volatility and offer greater returns to entice investors. Also known as junk bonds, investors with high risk tolerance generally invest in non-investment grade bonds for higher payouts.
Are BBB Bonds Investment Grade?
BBB bonds are investment grade bonds per Standard & Poor’s, Moody’s, & Fitch’s rating system. The table below looks at bond ratings by major global credit rating agencies & respective bond classes.
What makes a Bond High Yield?
Credit rating agencies rate both bonds and their issuers. The primary criteria behind the ratings are the financial situation of a company and its ability to repay the investors.
The higher yield of a junk bond is a key factor that attracts investors. The bonds issued by companies with poor financial health & creditworthiness and thus much more likely to default are considered non-investment grade bonds. Therefore, according to the Modern Portfolio Theory, these companies generally need to offer high interest or coupon rates to offset all the risks involved.
Credit rating agencies determine the rating of bonds in the high-yield market. But, investors should always conduct their investigations and credit analysis of bond issuers to determine the level & nature of risks involved.
Who issues High Yield Bonds?
In the 80s and 90s, most high-yield bonds were outstanding bonds of “fallen angel” companies, which were former investment-grade companies whose ratings had been downgraded. The companies selling these bonds mainly had dubious financial health and issued bonds to finance mergers, acquisitions, etc. Reputed investment banks of those times were the prime motivator behind the launch of the modern high-yield market in the 1980s, where high-yield bonds with sub-par ratings were sold.
Since the 80s, the high-yield bond market has evolved. Today, high-yield bonds have become a significant avenue for businesses with troubled financials to acquire working capital financing, repay lines of credit, etc. Rising-star startups with inadequate credit history also receive funds from the high-yield market for quick funding.
Economic growth and favourable market conditions often lead to expansion & increase activity in the high-yield bond market as investors become more risk-tolerant. At the same time, if more companies are downgraded below investment grade, the overall size of the high-yield market increases. Conversely, recessions and downturns lead to market shrinkage.
How to Invest in High-Yield Bonds
There are multiple ways to invest in high-yield bonds.
- Buy them directly from a stock or investment broker.
- Invest in mutual funds or exchange-traded funds that comprise high-yield bonds. This is a safer option as you have the fund manager as the middle-man who decides the proper bond to include in the fund.
Why invest in High Yield Bonds?
Portfolio diversification and high yield are the biggest reasons to invest in high yield bonds.
- Diversification: Non-investment grade bonds correlate weakly to their investment-grade counterparts, such as government and AAA-rated corporate bonds. They offer greater returns, and investing in them leads to diversifying one’s investment portfolio. While that does not eliminate risk, it mitigates the overall portfolio risk and increases the chances of getting consistent fixed-income returns.
- Enhanced current income: The average yield of the high-yield bond asset class is higher than that of other investment-grade bonds. Investing in them can enhance one’s current income. However, market conditions are central factors that determine yields and risks involved.
- Capital appreciation: Capital appreciation occurs when a bond’s par value increases during economic growth and/or the issuing business performs better. This is an essential factor to be considered during junk bond investments. Appreciation occurs when businesses report greater fiscal earnings, have their ratings upgraded, undergo mergers, acquisitions, or significant managerial overhauls, showcase better product developments, or experience any event that puts them in a better financial position and causes their business & bond ratings to rise. The capital gains from a high yield bond are much greater if the issuer follows through on their terms.
- Equity-like, long-term return potential: High-yield bonds, just like investment-grade bonds, are long-term fixed-income investments. These bonds behave quite like equities in a typical market environment. The higher income component of a high yield bond also contributes it its greater stability. And, when coupled with greater yields and the probability of capital appreciation, junk bond funds offer total returns quite similar to equities high-yield. Bondholders get higher priority over stockholders in case of any liquidation or bankruptcy. High-yield bond investors have a higher chance of recovering their investments than equity holders.
- Relatively low duration: The prices, par values, and interest rates of high-yield bonds are much more susceptible to economic conditions and the performance of their issuers. That’s why they have lower maturity periods of 10 years or less and are made callable by their issuers within 5 to 6 years. Daily fluctuations in market interest rates have little effect on these bonds, but during economic upturns, they outperform any other fixed-income securities. A high-yield bond can function well even when the market condition is low if its issuing company continues earning well.
What Happens to High-Yield Bonds When Interest Rates Rise
If market interest rates rise, the high-yield market can shrink as investors naturally opt for less-riskier fixed-income options. However, a rise in interest rates and economic upturns also means that the issuers of high-yield bonds will perform better. Thus, there’s a lower chance of default, and investors have a higher chance of getting high yields from their non-investment grade bonds.
Real-World Examples of High-Yield Bonds
High-yield bonds are not just issued by falling angels and rising stars. Many reputed companies going through financial troubles can issue high-yield bonds to acquire capital. Such incidences increase manifold during poor market conditions and economic downturns.
One of the most prominent examples is fallen angel Ford Motors, which issued three high-yield bond series after experiencing significant losses in the 2020 first quarter. The coupon rates of each series were 8.5%, 9.0% and 9.625 %, respectively. Investments poured in thanks to the global prominence of the company, and Ford Motors was able to raise $ 8 billion through non-investment grade bonds.
