High-yield bonds are a type of corporate bond issued by companies deemed to be at a higher risk of default on their debt obligations.
Credit rating agencies assign corporate debt a credit rating based on the issuing company’s perceived ability to maintain regular interest payments on their bonds and redeem them when they reach maturity.
High-yield, also called ‘junk’ bonds, receive lower ratings than investment-grade bonds, and because of their higher risk, they pay a higher yield.
What are the most common ways for companies to raise capital?
- Borrowing from banks or arranging credit lines from other financial services groups
- Raising equity on the stock market
- Selling bonds on debt capital markets
A bond is a promise to investors that the issuer will repay the face value on that bond after a fixed period, often five or 10 years. During this period, it will make interest payments that give the investor their annual yield.
The corporate bond market is split between securities issued by large, well-financed organisations that receive the highest credit ratings (investment-grade bonds) and those issued by companies deemed a higher risk by the credit rating agencies (high-yield bonds).
More on credit ratings later.
Why are they more risky?
Issuers of high-yield bonds are typically smaller, often start-ups or other capital-intensive companies.
The market for high-yield bonds has been historically less liquid than government bond or investment-grade bond markets.
Liquidity is a measure of the frequency and ease with which an asset can be bought or sold. Highly liquid assets are exchanged frequently and should be able to be bought or sold in quantity without materially affecting the price.
Illiquidity introduces risk at several points. It causes price volatility and makes it difficult if you want to sell your assets quickly.
These agents provide assessments on whether an issuer is likely to be able to meet its debt obligations.
- Can it maintain interest payments? When issued, the yield would be manageable, but if the company runs into any financial problems, what then?
- Is it likely to have the capital to redeem matured bonds? A 10-year bond matures after 10 years: can the issuing company maintain its debt obligations and still grow enough to redeem outstanding debt after this time?
There are three main rating agencies: Moody's, Standard & Poor's and Fitch Ratings. Below is a chart of the credit ratings they issue.
A credit rating will be issued ahead of the launch of the bond so the issuer and investors can agree pricing of the issue and the yield they can expect.
Why invest in high yield?
Because of their more risky nature, high-yield bonds are regarded as speculative, but many longer-term investors find room for them in their portfolios.
Combining assets of different quality in your investment strategy adds to your portfolio’s diversity. A diverse portfolio helps maximise profit while minimising risk – so long as potential losses from your speculative assets are more than covered by your high-grade investments.
Yes, high-yield bonds are risky, but there are ways of limiting the risk and still benefiting from the higher returns they can offer.
Not all junk issuers remain junk, just as investment-grade issuers can't always maintain their premium ratings.
So-called rising stars are junk-rated companies whose credit profile is improving. This means its credit rating will eventually be upgraded by the rating agencies. However, it is possible to find a sweet spot where yields remain high ahead of any upgrades.
Identifying a likely rising star is difficult, so absorb as much research and news as you can.
Rising stars have their counterparts: fallen angels are companies that once enjoyed investment grade ratings but whose creditworthiness has fallen to junk status.
Buying a fund or ETF
Many funds and exchange traded funds (ETF) offer access to the high-yield bond market.
The advantage of most of these is that they hold a wide variety of different issues, so the danger if just one of them defaults is smoothed by the performance of the others.
They are still vulnerable to economic risk and the threat of rising interest rates.
So what’s the conclusion?
Yes, junk bonds are risky, but every investment carries its own level of risk. Unless you are simply speculating (a strategy that’s inherently risky), there's room for a small amount of risk in anyone's portfolio.
The high-yield market periodically experiences higher levels of default, but the long-term average default rate is only 4%. The highest in recent years, during the credit crisis of 2009, was 10.3%.
The market is enjoying a resurgence – the top 10 high-yield bond funds all made returns above 10% in 2016.
But don't forget the outlook for interest rates and the economic environment. Any risk that higher rates could have a negative impact on the economy, and the junk bond market could turn.