A bond is a type of loan made by an investor to a borrower for a predefined period in return for regular payments in the form of interest until maturity. One type, known as junk bonds, are high yield bonds that pay higher interest rates than investment grade bonds because they come with lower credit ratings. As they are more likely to default, high-yield bonds pay a higher yield to compensate investors for this risk.
Bonds are differentiated by their credit quality, and they fall into two bond categories, non-investment and investment grade. Bonds are considered investment grade if they carry low default risk. High-yield bonds fall under the non-investment grade category and carry lower credit ratings. For investors positioned to take on higher credit risk levels, high yield bonds provide a good opportunity to enhance their portfolio diversification.
Based on their assessment, external rating agencies assign credit ratings to governments and companies issuing bonds. The rating helps investors to assess the health of the bond issuer and their ability to pay interest and return the principal as scheduled. To help the investor assess the bond’s credit quality, each rating agency has a similar hierarchy that compares that bond’s credit to that of other bonds.
Alongside the potential for better returns, high yield bonds come with specific risks such as higher default rates and higher volatility. However, they often behave differently from other assets in the fixed income world, and can therefore provide an important route for fixed income portfolio diversification.
The high yield bond market has historically presented a long-term return profile that broadly resembles equities. The prices of high yield bonds, like equities, can rise as a result of a wider economic upturn or improved financial performance of the bond issuer. However, their higher return component means that high yield bonds are generally less volatile than most equities.
Investing in high yield bonds calls for high risk tolerance. First, the financial health of the bond issuer (government or corporate) can change and the rating agencies can upgrade or downgrade the rating. In particular, during an economic downturn, the price of bonds can fall dramatically. It’s therefore important to regularly monitor a bond’s rating. When the economy is strong, high-yield bonds tend to perform well, just like stocks.
Second, if a bond is sold before it reaches maturity, any upgrades or downgrades in its rating can impact the price other investors are willing to pay for it, thus affecting its value. Also, if sold before maturity, the actual value of a high yield bond may be less than its face value. The face value is the amount the investor receives upon the bond’s maturity.
Default is probably the most significant risk associated with a high-yield bond. To deal with default risk, the best solution is diversification, although that increases investor fees and limits strategies. Nevertheless, high yield bonds are a good strategy to preserve capital and provide regular income.
All bonds, including junk bonds, face interest rate risk. In general, bond prices and market interest rates move in opposite directions. When interest rates rise, the price of bonds decreases. Typically, the longer the bond’s duration, the more it’s likely to be affected by future interest rate hikes, as there is more time for potential interest rate changes.
