Companies and governments issue bonds to raise money, and they pay only as much interest as they have to pay to attract investors. A financially rock-solid company or government will attract investors with an interest rate that is only a little above the inflation rate. A financially troubled borrower has to offer a better deal.

  • The low-yield bond is better for the investor who wants a virtually risk-free asset, or one who is hedging a mixed portfolio by keeping a portion of it in a low-risk asset.
  • The high-yield bond is better for the investor who is willing to accept a degree of risk in return for a higher return. The risk is that the company or government issuing the bond will default on its debts.

In the worst-case scenario, which is bankruptcy, bondholders are first in line for repayment, but getting back all or even some of the money invested is a faint hope.

Understanding Bond Yields

Bonds make periodic payments of interest, known as coupon payments, to the bondholder. A bond's indenture–that is, its contract–details the timing and method of payment.

Key Takeaways

  • The bond's rating tells you the degree of risk that the company issuing it will default on its obligations.
  • The lower the rating, the higher the yield will be.
  • The higher the rating, the safer your money will be.

Companies and municipalities frequently issue bonds to raise money for specific projects. It can be to their advantage to borrow the money rather than spend a chunk of the cash they have on their balance sheets.

Each bond issued is rated by one of three major rating companies, and the quality of the bond is determined by the quality of the issuer. The rating reflects the agency's opinion on the issuer's ability to make good on all of its coupon payments and return the money invested when the bond reaches its maturity.

In the investment world, any bond that is not a U.S. Treasury bond has some degree of risk, however slight.

The yield offered for the bond will reflect its rating. The higher the yield, the more likely it is that the firm issuing the bond is not of high quality. In other words, the company that issued it is at risk of default.

The Ratings and What They Mean

Three major credit rating agencies evaluate the bond issuers based on their ability to pay interest and principal as required under the terms of the bond. They are Standard & Poor's (S&P), Moody's, and Fitch Group.

  • The highest S&P rating a bond can have is AAA, and the lowest is CCC. A rating of D indicates that the bond is in default. Bonds rated BB or lower are considered low-grade junk or speculative bonds.
  • Moody's ratings range from Aaa to C, with the latter indicating default. Bonds rated Ba or lower are low-grade or junk.
  • Fitch ratings range from AA+ to C. Anything lower than BB- is deemed highly speculative.

High-Yield and Investment Grade

High-yield bonds tend to be junk bonds that have been awarded lower credit ratings. There is a higher risk that the issuer will default. The issuer is forced to pay a higher rate of interest in order to entice investors.

High-rated bonds are known as investment grade. They offer lower yields with greater security and a great likelihood of reliable payments.

There is a yield spread between investment-grade bonds and high-yield bonds. Generally, the lower the credit rating of the issuer, the higher the amount of interest paid. This yield spread fluctuates depending on economic conditions and interest rates.

The Old Reliable T-Bond

From the perspective of the professional investor, every bond that is not a U.S.Treasury bond (T-bond) has some degree of risk. The T-bond is the gold standard of investment-grade bonds. Its returns are notoriously low but its reliability is famously great.

On the other side of the risk spectrum, there are exchange-traded funds (ETFs) that invest only in high-yield debt. These ETFs allow investors to gain exposure to a diversified portfolio of lower-rated bonds.

This diversification across companies and sectors gives some protection against default risk. Still, a recession or a sustained period of high market volatility can lead to more companies defaulting on their debt obligations.