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What are High-Yield Bonds, and Should You Invest in Them? 

TABLE OF CONTENTS

What are High-Yield Bonds, and Should You Invest in Them? 

What are High-Yield Bonds, and Should You Invest in Them? 

Vantage Updated Updated Fri, 2024 January 26 09:25

While bonds have traditionally been preferred as fixed-income, low-risk instruments, not all bonds are created equal. In fact, there are some bonds that are closer to equities in terms of volatility and potential returns.  

These are known as high-yield bonds (or when there is significant risk, junk bonds), and bond investors will no doubt come across them sooner or later. High-yield bonds offer higher returns but also come with a greater risk of default. It’s important to understand what counts as a high-yield bond, its features and characteristics, how such bonds work; to decide whether they are suitable for your portfolio.  

What are high-yield bonds? 

Typically, bonds may be categorised into two groups: Investment-grade bonds, and non-investment-grade bonds.  

Investment-grade bonds have a high credit rating by rating agencies, carrying at least BBB- from Standard & Poor’s, and Fitch, or a minimum Baa3 from Moody’s.  

On the other hand, bonds that are rated Ba1 or lower by Moody’s or BB+ or lower by Standard & Poor’s or Fitch are considered non-investment grade. 

Credit ratings are estimations of risk, and non-investment-grade bonds are deemed to carry much higher risk than investment-grade bonds.  

In order to compensate inventors for taking on higher risk, such non-investment-grade bonds offer a higher yield. This has led such bonds to be known as high-yield bonds.  

Additionally, high-yield bonds are typically broken down into two subcategories: 

  • Fallen angels: A bond that has been downgraded by a major rating agency and is headed toward junk-bond status because of the issuing company’s poor credit quality. 
  • Rising stars: A bond with a rating that has increased because of the issuing company’s improving credit quality. A rising star may still be a junk bond, but it’s headed toward being investment quality. 

Understanding bond risk ratings 

At this point, it might be helpful to take a short detour to explore the significance of credit ratings when it comes to bonds.  

Let’s take Fitch’s rating scale as an example. The agency defines credit ratings as “forward-looking opinions on the relative ability of an entity or obligation to meet financial commitments. (They are) indications of the likelihood of repayment in accordance with the terms of the issuance” [1].  

In other words, credit ratings for a bond indicate the likelihood of default.  

As a bondholder, you’re essentially loaning out your money to the bond issuer, and you want the issuer to pay the coupon payments as scheduled. You also want to be able to redeem your bond at maturity.  

Should the issuer miss a coupon payment or be unable to pay back the bond at maturity, the bond has gone into default.  

Fitch’s ratings scale runs from AAA to D, and have different definitions as follows. 

Fitch rating Definition 
AAA  Highest credit quality with lowest expectation of default risk. Assigned only in cases of exceptionally strong capacity for payment of financial commitments. 
AA Very high credit quality with very low default risk.  
High credit quality with low default risk.  
BBB Good credit quality and expectations of default risk is currently low. Repayment capacity is considered adequate but may be impaired by adverse business or economic conditions. 
BB Speculative, with elevated vulnerability to default risk, particularly during adverse changes in business or economic conditions over time. 
Highly speculative, with material risk of default. But there remains a limited margin of safety. 
CCC Substantial credit risk, and default is a real possibility. 
CC Very high levels of credit risk, with default probable.  
Near default, with payment capacity irrevocably impaired. 
Default, with the issuer having entered into bankruptcy filings, administration, receivership, liquidation or other formal winding-up procedure or that has otherwise ceased business and debt is still outstanding. 
Table 1: Fitch rating scale rating [2] 

Recall that for Fitch, bonds with ratings of BB and below are considered non-investment grade, or high-yield bonds.  

High-yield bonds are almost always corporate bonds issued by companies and commercial organisations, as these issuers have less ability to avoid default.  

By comparison, governments are far less likely to default, and thus government bonds very rarely fall into non-investment grade classification.  

Thus, know that if you invest in high-yield bonds (or a high-yield bond fund) you are most likely dealing with private organisations and businesses.  

What are the key characteristics of high-yield bonds? 

Potentially higher returns but comes with higher risk and volatility  

While high-yield bonds may offer more lucrative returns than investment-grade bonds, they come with a relatively higher degree of risk.  

It can be easy to be attracted by a high coupon payment, but if the issuer delays or misses the payment, the value of the bond will plunge. This is because bonds are tradeable on the secondary market, and bondholders seeking to cut their losses may even be willing to sell their bonds below face value. This will quickly devalue your investment.  

In such a scenario, you can choose to hold on to your bond and hope that the issuer recovers and makes good on their obligations, allowing you to redeem your bond at face value at maturity. But this is highly uncertain and emotionally difficult to see through.  

This is how high-yield bonds can behave like stocks and equities, introducing similar levels of volatility. This is contrary to the purpose of holding bonds in the first place, which for many bondholders is to avoid volatility. 

Sensitive to interest-rate changes 

High-yield bonds are vulnerable to interest rate changes. Because bond interest rates are tied to central bank interest rates, they go up in tandem with interest rate hikes.  

Thus, when interest rates are raised, high-yield bonds can experience lower demand, as investors can get higher returns with lower risk by investing in newer investment-grade bonds issued by governments instead [3]

However, rising interest rates may also indicate that an economy is doing well. This may lead to increased appetite for high-yield corporate bonds as bullish market sentiment prevails [4]

Higher liquidity risk  

Even though they are tradeable on the secondary market, high-yield bonds may face higher liquidity risk.  

This means you may not be able to sell your bonds at a time and price that represents its true value, creating serious implications for your overall returns.  

How much yield do high-yield bonds provide? 

At this point, you may be wondering if high-yield bonds are worth the associated risks.  

Well, perhaps a look at some popular high-yield bond ETFs and their returns may help shed some light on the matter. We’ll use a bond issued by Apple Inc as a benchmark [5].  

Bond/Bond Fund Yield to Maturity 
AAPL 10May2028 Corp 5.26% (ask) 
iShares iBoxx $ High Yield Corporate Bond ETF (HYG) 9.3% 
iShares 0-5 Year High Yield Corporate Bond ETF (SHYG) 9.3% 
VanEck Fallen Angel High Yield Bond ETF (ANGL) 8.5% 
Vanguard High-Yield Corporate Fund Investor Shares (VWEHX) 7.8% 
Table 2: Bond and their yield to maturity [6] 

As you can see, the selected high-yield bond funds all achieved higher yield-to-maturity – a measure of the bond’s internal rate of returns if held to maturity – than the benchmark corporate bond.  

However, yield-to-maturity isn’t the only measure to consider; Apple Inc. is considered far less risky an issuer, and this fact may cause investors to favour its bond instead.  

Should you invest in high-yield bonds? 

It should be emphasised that while high-yield bonds are certainly more risky, that doesn’t mean they should be avoided at all costs. High-yield bonds can certainly have a place in some investors’ portfolios, especially with sufficient care and attention.  

Also, with high-yield bond funds and ETFs, investors can gain a measure of diversification and hedge against the risk of being overly concentrated in just a few high-yield corporate bonds.  

Another point to note is that the higher volatility native to high-yield bonds may make them well-suited for short-term strategies, such as day trading. Read more about how to trade bonds

Trade high-yield bonds with CFDs 

If you want access to the potential opportunities of the high-yield bond markets, but don’t want to take direct ownership of corporate bonds, you can try trading using Contracts-for-Difference (CFDs).  

When it comes to bond CFDs, traders have the opportunity to capitalise on price movements in the underlying high-yield bonds, which includes the ability to take short bond positions during market downturns.  

Trade the world’s most popular bonds with Vantage CFDs. Sign up now. 

References

  1. “Ratings Definitions – Fitch Ratings”. https://www.fitchratings.com/products/rating-definitions. Accessed 2 Nov 2023. 
  2. “Ratings Definitions – Fitch Ratings”. https://www.fitchratings.com/products/rating-definitions. Accessed 2 Nov 2023.
  3. “High-Yield Bond: Definition, Types, and How to Invest – Investopedia”. https://www.investopedia.com/terms/h/high_yield_bond.asp. Accessed 2 Nov 2023.
  4. “High-Yield Bond: Definition, Types, and How to Invest – Investopedia”. https://www.investopedia.com/terms/h/high_yield_bond.asp. Accessed 2 Nov 2023.
  5. “AAPL 4.000% 10May2028 Corp (USD) – Bond Supermart”. https://www.bondsupermart.com/bsm/bond-factsheet/US037833ET32. Accessed 2 Nov 2023.
  6. “7 of the Best High-Yield Bond Funds to Buy Now – U.S News”. https://money.usnews.com/investing/articles/best-high-yield-bond-funds. Accessed 2 Nov 2023.
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