What Are High-Yield Bonds?

High-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors.

Issuers of high-yield debt tend to be startup companies or capital-intensive firms with high debt ratios. However, some high-yield bonds are fallen angels that lost their good credit ratings.

Key Takeaways

  • High-yield bonds, or "junk" bonds, are corporate debt securities that pay higher interest rates because they have lower credit ratings than investment-grade bonds.
  • These bonds have credit ratings below BBB- from S&P, or below Baa3 from Moody's.
  • High-yield bonds offer investors higher interest rates and potentially higher long-run returns than investment-grade bonds but are far riskier.
  • In particular, junk bonds are more likely to default and display much higher price volatility.
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High-Yield Bond

Understanding High-Yield Bonds

From a technical viewpoint, a high-yield, or "junk" bond is pretty much the same as regular corporate bonds since they both represent debt issued by a firm with the promise to pay interest and return the principal at maturity. Junk bonds differ because of their issuers' poorer credit quality.

All bonds are characterized according to this credit quality and therefore fall into one of two bond categories: high-yield and investment grade. High-yield bonds carry lower credit ratings from the leading credit agencies. A bond is considered speculative and will thus have a higher yield if it has a rating below "BBB-" from S&P or below "Baa3" 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.

High-yield bonds are typically broken down into two sub-categories:

  • Fallen Angels: This is a bond that was once investment grade but has since been reduced to junk-bond status because of the issuing company's poor credit quality.
  • Rising Stars: The opposite of a fallen angel, this is a bond with a rating that has been increased because of the issuing company's improving credit quality. A rising star may still be a junk bond, but it's on its way to being investment quality.

Advantages of High-Yield Bonds

Higher Yields

Generally, investors in high-yield bonds can expect at least 150 to 300 basis points in additional yield compared to investment-grade bonds at any given time. In actual practice, the gain over investment-grade bonds is lower because there will be more defaults. Mutual funds and exchange traded funds (ETFs) provide ways to tap into these higher yields without the undue risk of investing in just one issuer's junk bonds.

Higher Expected Returns

While high-yield bonds suffer from the negative "junk bond" image, they actually have higher returns than investment-grade bonds over most long holding periods. For example, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) had an average annual total return of 6.44% between the beginning of 2010 and the end of 2019.

During that time, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) returned an average of 5.93% per year. This result is in accord with modern portfolio theory (MPT), which holds that investors must be compensated for higher risk with higher expected returns.

Disadvantages of High-Yield Bonds

Default Risk

Default is itself the most significant risk for high-yield bond investors. The primary way of dealing with default risk is diversification, but that limits strategies and increases fees for investors.

With investment-grade bonds, investors can buy bonds issued by individual companies or governments and hold them directly. When they hold bonds directly, investors can build bond ladders to reduce interest rate risk. Investors can also avoid the fees related to funds buy holding individual bonds. However, the possibility of default makes individual bonds too risky in the high-yield bond market.

Small investors should generally avoid buying individual high-yield bonds directly because of high default risk. High-yield bond ETFs and mutual funds are usually better choices for retail investors interested in this asset class.

Higher Volatility

Historically, high-yield bond prices have been much more volatile than their investment-grade counterparts. In 2008, high-yield bonds as an asset class lost 26.17% of their value in just one year. Between 1980 and 2020, a diversified portfolio of investment-grade bonds (including both corporate and government bonds) never lost more than 3% in a single calendar year.

On the whole, the volatility of high-yield bonds is closer to the stock market than the investment-grade bond market.