The Fundamentals of High-Yield Bond Investing

When attempting to understand high-yield or so-called junk bonds, it's important to carefully examine the common beliefs held about these bonds. As it turns out, despite their name, junk bonds are not as risky as they are commonly held to be. Here are some facts concerning junk bonds that many investors may not have considered fully:

  • In 2019, 28.2% of corporate debt was rated “junk” status. This means the market is quite diversified from what the term was understood to represent when it first became popular three decades ago.
  • Many times a “junk” status company is simply one that is doing its own thing regardless of market trends. This means that “junk” status doesn’t always mean a company is unstable.
  • It's important to note such junk bonds pay off a much higher rate than similar-sized investments elsewhere.
  • Given these facts, prudently investigating the junk bond market for the right investment is a worthwhile investment practice for investors looking to maximize ROI.

In short, high-yield bonds are riskier than lower yielding bonds, but they offer greater returns. So taking your time to investigate a junk status company may result in significantly larger returns than following traditionally “less-risky” investment opportunities. On the flip side, because the risk is greater, the total capital invested in junk bonds should remain lower than capital invested elsewhere to mitigate losses in the event such investments fail. When considering investing in a junk bond it's important to conduct a thorough investigation of its risks.

Advantages of High-Yield Corporate Bonds

Because of the higher yields junk bonds provide investors, they have slowly become more and more popular over the years. Given the fact that corporate bonds in general pay out higher yields than most government issued bonds, you can see the attraction given the other bond options available to investors. Though government bonds are the most reliable bonds, which make them the most popular, this reliability comes at a reduction in ROI.

Bonds also offer some significant advantages to investors over equity investments. Here are some advantages:

  • Owning a bond does not mean you have an interest in the company. You are paid out based on a rate that is stable over a period, which is something equity investments do not guarantee.
  • Because you're not concerned with day-to-day profits when investing in a bond, there is less need to be involved with the business overall.
  • Corporate bonds allow investors more diversity in their investing options. They can choose to invest in any number of different economic sectors. This makes them ideal to fill out a fixed-income or equity portfolio if you're in need of a little more diversity.
  • Because of their fixed-income schedule, corporate bonds often provide investors a reliable and convenient steady income other investment opportunities do not. There are, however, exceptions to this, like zero-coupon bonds and floating-rate bonds, which offer different payment schedules and options.
  • Because they can be sold at any time, including prior to maturation, corporate bonds are far more liquid than several other investment opportunities.
  • The maturity date for a corporate bond is established when it is issued. There are three basic maturity date ranges, which provide a lot of flexibility to investors:
  1. Short Term – Short-term notes are bonds with maturity dates of five years or less.
  2. Medium-Term – Medium-term notes are bonds with maturity dates between 5 and 12 years.
  3. Long-termLong-term notes are bonds with maturity dates over 12 years

The Risks of High-Yield Corporate Bonds

To be clear, the risk of default isn’t significant for junk or high-risk bonds. In fact, the historical averages for annual defaults (from 1981 to 2019) are only about 4% a year. This means that there isn’t a large impact on junk bond performance due to actual defaults.

The risk, then, comes in the form of the volatility of the bonds performance when compared to other sectors of the bond market. Indeed, they do perform well over time as the 4% default shows. However, they get risky when market environment conditions turn sour. When the market, as it did in 2008 for example, sours, junk bonds can fail across the board in affected business sectors. In short, when the economy suffers, junk bonds are far more likely to fail than traditional bonds. The more stable the economy is as a whole, the more this risk is minimized.

The Historical Performance of Junk Bonds

Despite the devastating short-term effects issues like the savings and loan scandals in the 80s, the 2008 recession and the dot-com bust in the early 2000s have had on high-yield corporate bonds, they have continued to maintain strong growth in performance overall, revealing the market's ability to rebound along with the economy.

When comparing their historical performance specifically with other bonds, junk bonds averaged a relative 5.5 percentage points better than US Treasury bonds from January 1997 to October 2020. This growth, however, also exhibits the inherent volatility of such bonds. The spread has been as high as 21.82 and as low as 2.44.

Clearly, the lesson here is that high-yield bonds are best when the economy is stable and experiencing growth. On the other hand, high-yield bonds do not perform so well if the economy is not healthy or if there is the risk of a recession. High-risk investments will be the first to go in times of trouble.

When it comes to interest rate changes, high-yield bonds are not impacted as much as lower-yield bonds, where changes would be felt more significantly in returns.

The Bottom Line

Given the historical performance of high-yield corporate bonds, it is fair to ask: for what kind of investor do high-yield corporate bonds make the most sense? 

In general, such junk bonds are seen by investors as a sort of “middle-ground” between bonds and the stock market. Yes, they are more volatile than "normal" bonds, but not as volatile stocks. Additionally, they offer greater payout than lower yielding bonds, but not as much as stocks do – over the long-term. Over time, their ability to perform in line (correlate) with the stock market while offering less risky investments has continued to make them an attractive third option for many different types of investors, ranging from private to institutional investors.

Overall, investors who want high yields and the potential for long-term appreciation from their investments and who can withstand the higher risk of such bonds should investigate the high-yield bond market. However, because these bonds are volatile, investors who cannot tolerate risk or who are only looking for a short-term option should look elsewhere.