Are high-yield bonds better investments than low-yield bonds?

By Matt Lee AAA
A:

Most bonds typically make periodic payments, known as coupon payments, to the bondholder. A bond's indenture, which will be known when the purchaser buys the bond, will specify the coupon payments to be paid by the bond.

Different companies will issue different bonds to raise financial capital, and the quality of each bond is determined by the quality of the issuing firm, which depends on the firm's ability to pay all coupon payments and the principal at maturity. The yield offered is used to compensate investors for the risk they incur when purchasing a given company's bond. The higher the yield, the more likely it is that the firm issuing the bond is not of high quality - in other words, the more likely the firm is to not make coupon and principal payments. When a firm misses a payment, the bond is said to be in default, and the risk that this will happen is known as default risk.

Bonds rated 'BB' or lower on the bond rating scale are considered lower grade (junk or speculative) bonds and carry a larger amount of default risk than a bond that is rated above 'BB' (also known as investment grade). The highest rating a bond can have is 'AAA', and the lowest is 'CCC'. A rating of 'D' indicates the bond is in default. (To learn more, see What Is A Corporate Credit Rating?)

So, which bond is better to purchase? It depends on the amount of default risk you as an investor want to be exposed to. If the issuer does not default, the higher yield bond will give you a higher return, in the form of coupon payments, but the default risk is higher than what you would face with a lower yield, higher grade bond. If you purchase a higher grade, lower yield bond, you are exposed to less default risk, and you have a higher chance of getting all of the promised coupon payments and the par value if you hold the bond to maturity.

For more information on high- and low-yield bonds, see High Yield, Or Just High Risk?, Junk Bonds: Everything You Need To Know and our Bond Basics Tutorial.

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