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High-yield bonds, also commonly known as junk bonds, have lower credit ratings than investment grade corporate bonds as well as other types of bonds. Since they have lower credit ratings, there is a higher risk of default by the corporate issuers. To entice investors to buy the bonds, the bonds pay a higher rate of interest. Investors who are seeking yields greater than those of government Treasury bonds may be willing to take on the additional risk in return for greater yield.

There are highly liquid exchange-traded funds (ETFs) that invest in high-yield debt. These ETFs allow investors to gain exposure to a diversified portfolio of high-yield bonds without holding the debt of a single company. This diversification across companies and sectors can protect against default risk. Still, even with diversification, periods of high market volatility can lead to a much larger number of companies defaulting on their debt obligations.

Credit Rating and Yield Spread

High-yield bonds have a credit rating below BBB from Standard & Poor’s and below Baa3 from Moody’s. These two major credit rating agencies that evaluate the bond issuers based on their ability to pay interest and principal as required under the terms of the bond. Although many investors rely heavily on these ratings, the agencies have incorrectly ascertained the amount of risk for debt securities in the past. Most notably, during the 2008 economic crisis, credit rating agencies failed to identify significant risks with mortgage-backed securities.

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.

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