High Yield Bonds
What is a “High Yield Bond”?
High Yield Bonds are fixed income securities rated below “BBB−“ or “Baa3” by credit rating agencies. Any bonds rated above these tiers are known as investment grade bonds. High yield bonds typically offer higher rates of interest relative to investment grade bonds due to their lower credit rating and higher risk of default. They may increase in price should the issuing company’s outlook or the economic conditions improve. In addition, high yield bonds, also known as “junk bonds”, offer the benefits of low correlation with other asset classes and sectors within the fixed income segment (such as US Treasuries for example) as well as lower sensitivity to changes in interest rates.
Key Learning Points
- High yield bonds are those rated “BBB−“ by S&P or “Baa3” or below by Moody’s credit rating agencies
- Companies which issue high yield bonds typically have a high debt to equity ratio or are early-stage companies yet to achieve a good credit rating
- They are also known as “junk” or “non-investment grade”
- “Junk” bonds could be further broken down into two sub-categories:
- ‘Fallen angels’ – those that once were rated as investment grade, but due to the issuer’s declining credit quality were reduced to high yield
- ‘Rising stars’ – where issuers with improving quality and characteristics, which are on their way to be upgraded to investment grade
- They generally provide higher coupons (regular interest payment that the bondholder receives until the bond matures) than investment grade bonds due to the perceived higher default risk involved
- A high yield bond offers the potential of capital appreciation should its price increase on the back of credit rating upgrade
- Historically, high yield bonds offered equity-like returns, but using less volatility over the long-term
There are a few key benefits that high yield bonds can offer: firstly a low correlation with other asset classes, which offers portfolio diversification benefits. Investors could also expect lower duration (sensitivity to changes in interest rates, i.e. interest rate risk) as “junk” bonds are often issued with shorter terms of 10 years or less. High yield bondholders may also enjoy an enhanced current income as these instruments tend to offer a higher yield (the interest received) relative to higher quality bond issues in order to attract capital. These levels vary in-line with the prevailing market conditions, but generally when an economic downturn occurs and default risk increases, income payments tend to increase.
Another advantage of high yield bonds is their ability to grow in price and therefore offer potential capital appreciation and higher total return. This is usually as a result of improved outlook or performance of the issuing company – events may include credit rating upgrade, positive results report, positive outlook for new product development, etc. Last but not least, it should be highlighted that bondholders rank with higher priority compared to equity shareholders and in the event of company liquidation. In terms of performance, over the long-term high yield bonds are expected to deliver equity-style returns, but can achieved using lower volatility.
What are the Risks?
The main risk with high yield bonds is that investors expose themselves to default risk which may result in a loss of the initial investment. They also tend to be more sensitive to the economic outlook particularly during times of economic turbulence when default risk can significantly increase. In addition, high yield bonds are more volatile relative to investment grade peers. Therefore they could be best utilised as part of a well-diversified portfolio.