Takeaways
- High-yield bonds pay higher interest rates than investment-grade bonds.
- High-yield bonds are often called “junk bonds” because they have high risk.
- High-yield bonds are more likely to have higher price volatility and default.
- Rating agencies like Standard & Poor’s, Fitch, and Moody’s rate high-yield bonds.
- Investors with a high-risk appetite and seeking outsized returns invest in junk bonds.
What Is a High-Yield Bond?
A high-yield bond is a debt security issued by an entity with the promise to pay regular interest payments and the principal upon maturity. They can be a great way to earn passive income. Traditionally, high-yield bonds pay a higher interest rate than regular investment-grade bonds because they have a higher risk of defaulting on payments.[1] High-yield bonds are often called “junk bonds” because they receive a low credit rating from rating agencies like Standard & Poor’s, Fitch, and Moody’s.
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High-yield bond bonds have components like investment-grade bonds. Here are some critical components:
- Par Value: The amount on the front of the bond (often called face value) an issuer promises to repay. Bonds are commonly issued with a par value of $1,000.
- Coupon Rate: The interest rate promised by the bond issuers to the bondholder, paid annually or semiannually. This interest rate starts from the date of issuance to the bond maturity.
- Maturity: The date the bond term ends is when the bondholder's original principal payment is due. Bond maturities can vary but usually last from seven to 10 years.
- Credit Rating: Credit rating agencies assign risk to each type of bond, with the two main categories splitting bonds into investment-grade or non-investment-grade bonds.
Companies that are very capital-intensive with high debt ratios issue high-yield bonds because there is a perceived risk of these companies defaulting on their payments. Additionally, startup companies can also issue junk bonds because they have a short, high-risk track record and an unproven business model. Bonds that receive a BB rating or below by Standard & Poor’s and Fitch and a Ba or below rating by Moody’s are considered high-yield bonds.
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Credit Rating for High-Yield Bonds
When a company wants to issue a debt security like a bond to raise capital, it must undergo a host of banking and regulatory hurdles. Part of the bond issuance process is getting a bond rating from a credit rating agency (more on this process below). Standard & Poor’s, Fitch, and Moody’s are the primary bond credit rating agencies.
These credit rating agencies evaluate the company or firm, analyzing their creditworthiness – the likelihood of default or inability to make debt payments promptly – and assign the bond a rating.
Companies with healthy balance sheets and solid financial footing tend to receive an investment grade rating, while companies with high risk get a non-investment grade rating.
Investment-Grade Bond Rating
| Standard & Poor's Rating | Description |
|---|---|
| AAA | Highest rating, low risk. |
| AA | High quality, strong company. |
| A | High quality, low risk |
| BBB | High quality, growing risk |
| BBB- | Lowest high-quality rating |
Non-Investment Grade Bond Rating
| Standard & Poor's Rating | Description |
|---|---|
| BB+ | Highest speculative grade |
| BB | High risk, less vulnerable to near-term events. |
| B | High risk, vulnerable to near-term events |
| CCC | High risk, needs favorable events |
| CC | High risk, default is close |
| C | High risk, default is imminent |
| D | In default or bankrupt |
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How Does the Rating Process Work?
The rating process for companies raising debt capital involves a rating request from a prospective bond issuer. The rating agencies conduct an initial evaluation and meet with company management. The credit rating agency then starts an intensive evaluation and rates and votes on the bond rating.
Once the rating agencies have determined the bond issuers' rating, they notify the bond issuers. If the bond issuer decides to proceed with the debt financing, they disseminate the bond rating publicly. Once the bonds are issued, the credit ratings are regularly monitored, and bond ratings can be reevaluated.[2]
Advantages of High-Yield Bonds
High-yield bonds exist for a reason. There is considerable investor appetite for these bonds. Here are some advantages to high-yield bonds:
1. Higher Returns
Investors gravitate to high-yield bonds for the promise of higher returns on their investments. While high-yield bonds have higher coupon rates than investment-grade bonds, they also carry the risk of default. If a junk bond defaults, you might not generate a better return than if you had simply invested in an investment-grade bond.
2. Diversification
High-yield bonds can enhance your portfolio diversification, providing needed exposure to certain types of businesses, investment risk profiles, and returns. Bond diversification helps reduce the exposure to very poor or high-performing assets and allows you to spread risk over a spectrum of investments, which can protect your investment portfolio.
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Disadvantages of High-Yield Bonds
While you might want higher rates of return, there is always a risk to investing in speculative classes of assets like high-yield bonds. Here are several disadvantages to high-yield bonds:
1. Interest Rate Risk
There is an inverse relationship between market interest rates and bond prices. The higher interest rates go, the lower the bond prices fall. This relationship paves the way for interest rate risk. If you buy a bond with a 3% coupon rate and interest rates rise to 5%, the price of your bond will fall.
Bonds with a longer term, or time from issuance to maturity, are susceptible to higher interest rate risk. As a result, investors who want to invest in debt securities can offset this risk by also investing in higher-quality debt securities like U.S. Treasuries.
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2. Default Risk
Default risk is high for non-investment grade bonds. Default risk is the risk that the lender will not make timely interest or principal payments. Nonpayment could result in a severe investment loss for you.
Diversification helps reduce the loss of your investments. To hedge against default risk, you can build a bond ladder to spread your investments over time and interest rates.
The reason high-yield bonds come with a higher coupon rate is that issuers cannot find investors willing to accept their bonds at lower interest rates. As a result, these companies are forced to issue high-cost debt because investors find their businesses highly susceptible to market conditions and business trends and are potentially vulnerable to near-term bankruptcy.
3. High Volatility
A well-understood fact is that high-yield bond markets respond differently to adverse market conditions than investment-grade bonds. Because these bonds carry a high degree of investment risk, when times get tough, investors are more likely to shed these assets from their portfolio in favor of “haven” assets like dividend-paying stocks or commodities (e.g., Gold, Silver, Copper).
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4. Liquidity Risk
Liquid assets are bought and sold easily in a readily accessible market. This liquidity is an advantage to investors because if investors want to sell or buy an asset, they can do so quickly. A liquid asset receives a liquidity premium in the eyes of investors. Liquidity also offers price stability to investors.
Bond liquidity risk is the risk that you will not be able to sell your bond at the time and price you want. Compared to investment-grade bonds, non-investment-grade bonds have more liquid risk. You should factor this into your investment decision.
How to Invest in High-Yield Bonds
Investing in high-yield bonds is very similar to investing in stocks. You can invest in bonds through your online brokerage accounts by investing in mutual funds or ETFs with high-yield bonds as part of their fund holdings. These funds are managed by a portfolio manager who curates the bonds included in the fund.
Alternatively, you can buy high-yield bonds directly from a broker-dealer. However, most investors invest in high-yield bonds through exposure in their brokerage holdings or retirement savings.
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High-Yield Bond Issuers
Companies issue bonds because they need access to capital to help them restructure their business, pursue new business strategies, hedge against seasonal cash flow issues, or fund new business projects. As a result, bonds are issued by companies of varying industries, market capitalization, and geographies.
- High-Risk Companies: These companies are called “Fallen Angels” because they previously issued investment-grade bonds but have fallen in quality over time due to declining business conditions or increased debt loads.
- Bankrupt Companies: Companies trying to emerge from bankruptcy may issue high-yield bonds to exit bankruptcy on the promise of implementing a new business plan.
- Start-Ups: New companies can issue debt to access capital to implement growth plans. Startup bonds are essentially convertible notes sold to investors to generate capital to begin business operations. Interest typically accumulates over time and then converts to the stock based upon set triggers (e.g., IPO, acquisition, or liquidation).
- Leverage Buyouts: A company set to acquire another company may do so through a leveraged buyout. In this transaction, the acquiring company takes out a large amount of debt in the form of bonds to raise the capital required to buy the new company. The new company will have a large debt load, so these bonds are typically graded non-investment grade.
Smart Summary
Contemplate your portfolio diversification, time horizon, and risk appetite when investing in high-yield bonds. Non-investment grade bonds can increase your overall return on investment and act as a catalyst to your portfolio. If you don’t want to invest directly in these types of bonds, you can gain exposure through mutual funds or ETFs. Maintaining the appropriate allocation of stocks and bonds in your portfolio is a smart money habit.
(1) U.S. Securities and Exchange Commission. High-yield Bonds (or Junk Bond). Last Accessed January 20, 2025.
(2) S&P Global. Guide to Credit Rating Essentials. Last Accessed January 20, 2025.
