What is a High-Yield Bond?
A high-yield bond is a high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds. Issuers of high-yield debt tend to be startup companies or capital-intensive firms with high debt ratios.
Understanding High-Yield Bonds
These bonds are also known as "junk bonds."
Based on the two main credit rating agencies, high-yield bonds carry a rating below "BBB" from S&P, and below "Baa" from Moody's. Bonds with ratings at or above these levels are considered investment grade. Credit ratings can be as low as "D" (currently in default), and most bonds with "C" ratings or lower carry a high risk of default; to compensate for this risk, yields will typically be very high.
All "junk" connotations aside, high-yield bonds are widely held by investors worldwide, although most participate through the use of mutual funds or exchange-traded funds. The yield spread between investment grade and high-yield will fluctuate over time, depending on the state of the economy, as well as company and sector-specific events.
Generally, investors in high-yield bonds can expect at least 150 to 300 basis points greater yield compared to investment-grade bonds at any given time. Mutual funds provide a good way to gain exposure without the undue risk of investing in just one issuer's junk bonds.
High-Yield Bond Market Performance
Central banks around the world, such as the Federal Reserve, European Central Bank (ECB) and Bank of Japan, have taken measures to inject liquidity into their economies and keep credit readily available, thereby lowering the costs of borrowing and eating into the returns of lenders. As of January 2018, the Federal funds rate stood at 1.5%, and $7.3 trillion in sovereign bonds, or government debt, offered a negative yield, after accounting for expected inflation.
This would normally have caused investors to look towards other markets to generate a higher rate of return, but high-yield bond markets have been volatile. In December 2017, high-yield bonds suffered the second largest outflows of any funds, largely due to the Tax Cuts and Jobs Act, which limits the amount of tax deductible interest expenses. Roughly $2.5 billion flowed out of bond funds in December. The outflows signaled an abrupt change from 2016, when $8.34 billion poured into top high-yield active categories of funds.