High-Yield Bond

High-yield bonds are a type of debt instruments which offer a higher interest rate than bonds with a higher credit rating. This bond is also called a junk bond because of its high default risk. There is an inverse relationship between interest rates and credit scores of these bonds 

Issuers of High-Yield Bonds

In general, issuers of junk bonds are some new or capital intensive companies which are in need of investments. Also, companies with a debt burden experience this need as well. The promise of high interest rates is the only way they have of attracting investors. This is their competitive advantage over bonds with higher credit ratings. Therefore, investors with riskier investment strategies might consider junk bonds as an opportunity to gain more profits.

Besides startups, high-yield bonds can be issued by previously reliable companies which later lose their credit scores under unfortunate circumstances. Otherwise, these junk bonds are known as “fallen angels”. The bond might become a fallen angel, if a company suffer from significant decrease in income or increase in debt. Either of these scenarios put a risk on the company’s ability to pay the bond debt back to investors.

The opposite type of “fallen angels” is “rising stars”. These bonds, in contrast, increase their initial credit ratings because of the company’s successful capital management and improving investment quality. Despite the increase in ratings, rising stars still might be junk bonds, but their progress might gradually lead them to investment-grade status.

High-Yield Bonds credit ratings

There are a few well-known credit rating agencies which estimate companies’ ability to repay a bond debt. Each of them uses a specified rating system which reflects the companies’ credit scores. Let’s take a look at how high-yield bonds are defined by these agencies:

• According to Moody’s, these bonds are considered to be below “Baa3”.
• By S&P, they are below “BBB-”.
• By Fitch, they are below “BBB-” as well.

Bonds with credit scores higher than these levels are considered to be trustworthy and reliable. Bonds with a “D” rating are currently in default, and bonds with a “C” rating are highly likely to default soon. 

Pros and cons of investment in High-Yield Bonds 

One of the most obvious bonuses of investment in high-yield bonds is reflected in its name itself – it’s higher yields and sometimes higher returns. Junk bonds always outperform creditworthy bonds by the expected income.

However, note that this income is less stable than the one that you get from bonds with high credit scores, which lead us to some of the high-yield bond disadvantages. The risk of the company’s inability to pay the debt back endangers your investments. Instead of high revenues, you might get less than you invested in or nothing at all.

Another disadvantage of junk bonds is their high volatility level. They are volatile as the stock market. The history showed that the value of these bonds could change by more than 20% in a year, while high-grade bonds have never lost this much for the last 40 years.

Strategies to reduce investment risks

Small or less experienced traders are recommended to avoid individual high-yield bonds because the chances of losing your investments are high. However, If you decide to include this type of securities in your portfolio, it might be better to consider high-yield bond funds. They are more prepared for the associated risks.

Mutual funds and exchange traded funds (ETFs) might lower the risks by investing in various high-yield bonds at the same time, or by mixing them with more reliable bonds and other financial instruments. If any of the junk bonds defaults, losses will be compensated by extra returns from other instruments. As an example, let’s consider SPDR Blackstone Senior Loan ETF current return in 2022. It’s around -2.86%, which is a negative figure of income, but still it’s far from causing significant damages to investors, while some individual junk bonds might drop dramatically.

This diversification strategy is stated in the modern portfolio theory (MPT) and helps investors to get higher earnings by combining different financial instruments.