High-Yield Bonds: Understanding Risk & Potential Returns

A high-yield bond is a bond that carries a relatively higher interest rate as a result of its lower credit rating, compared to investment-grade bonds. It is a corporate bond with a credit rating below Baa3 from Moody’s or BBB- from Standard and Poor’s (S&P)S&P – Standard and Poor'sStandard & Poor’s is an American financial intelligence company that operates as a division of S&P Global. S&P is a market leader in the and Fitch.

Summary

• A high-yield bond, also known as a junk bond, is a corporate bond that is rated below BBB- by S&P or Baa3 by Moody’s.
• High-yield bonds offer higher yields and potential for capital gains, but they are also riskier and more volatile during economic downturns than investment-grade bonds.
• High-yield bonds may be upgraded to investment-grade bonds, as investment-grade bonds can also be downgraded to high-yield bonds, depending on the changes of the issuer’s financial performance and creditworthiness.

High-Yield Bonds and Credit Ratings

Rating services, such as Moody’s, S&P, DBRS, and Fitch, measure the quality and riskiness of bonds and provide credit ratings. Multiple factors that impact the possibility of default and loss severity are taken into consideration. The higher the credit rating, the less risky a bond is and vice versa.

Corporate bonds with credit ratings of Baa and above (including A, Aa, and Aaa) from Moody’s or BBB and above (including A, AA, and AAA) from S&P or Fitch are classified as investment-grade bonds. The bonds with credit ratings below Baa or BBB fall into the high-yield category, which is also known as “junk bonds.”

High-yield bonds are characterized by a lower credit quality than investment-grade bonds, considering their higher possibility of delays and default of interest or even principal paymentsPrincipal PaymentA principal payment is a payment toward the original amount of a loan that is owed. In other words, a principal payment is a payment made on a loan that reduces the remaining loan amount due, rather than applying to the payment of interest charged on the loan.. Investors expect to be compensated by higher rates of return for the higher risks that they take. It is the reason why the bonds must be issued with yields higher than the ones with better credit quality.

High-Yield Bonds vs. Investment-Grade Bonds

Despite the name “junk bonds,” high-yield bonds still offer certain advantages compared to investment-grade bonds. The most obvious one is their higher yield. Bonds rated below investment grade are issued with higher yields to attract investors. The spread is typically around 150-300 bps.

Investors who are seeking higher returns with a larger risk appetite may prefer to add high-yield bonds into their portfolios rather than investment-grade bonds. High-yield bonds also provide the potential for higher capital appreciation. If the issuer company improves its financial performance or the economy enters an expansion stage, the price of the company’s high-yield bonds might increase substantially.

Besides the investment benefits, high-yield bonds can be used as a risk indicator. The trading volumes and prices of the bonds reflect the risk sentiment of the market.

High credit default risk is the major drawback of high-yield bonds that investors are most concerned about. Investors with a low level of willingness and ability to bear risks usually avoid investing in high-yield bonds. The price of a high-yield bond is also more volatile than that of an investment-grade bond.

Investors are highly sensitive to any deterioration of the financial situation of a high-yield bond issuer. With lower credit quality, issuers of high-yield bonds are more vulnerable during economic downturns, and the possibility of credit defaults spikes for the companies. Thus, the price of the bonds is more volatile compared to the investment-grade ones, which makes them an unlikely safe havenSafe HavenA safe haven is a term that refers to an investment that is anticipated to maintain or increase in value during times of economic downturn.

The credit rating of a bond is not permanent. Rating agencies will adjust their ratings if the issuer’s financial performance has improved or worsened. A high-yield bond can be upgraded into the investment-grade category (“rising star”), as an investment-grade bond can also be downgraded to a junk bond (“falling angel”).

Real-World Examples of High-Yield Bonds

Issuing high-yield bonds is a common way for financially depressed companies to raise capital, especially during economic downturns. Hit by the COVID-19 pandemic lockdown, Ford Motors issued three series of high-yield bonds in April after reporting a significant amount of loss for the first quarter of 2020. Each series offered an interest rate of 8.5%, 9.0%, and 9.625% respectively, and in total raised $8 billion for Ford.

Besides purchasing individual bonds, investors can get exposure to high-yield bonds through ETFs, which provide better diversificationDiversificationDiversification is a technique of allocating portfolio resources or capital to a variety of investments.The goal of diversification is to mitigate losses. iShares iBoxx $ High Yield Corporate Bond ETF (HYG) tracks the Markit iBoxx USD Liquid High Yield Index. It is offered by BlackRock, and mainly composed of BB AND B Rated corporate bonds.

More Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Credit RatingCredit RatingA credit rating is an opinion of a particular credit agency regarding the ability and willingness an entity (government, business, or individual) to fulfill its financial obligations in completeness and within the established due dates. A credit rating also signifies the likelihood a debtor will default.
• Investment-Grade BondsInvestment-Grade BondsAn investment-grade bond is a bond classification used to denote bonds that carry a relatively low credit risk compared to other bonds.
• Fitch RatingsFitch RatingsFitch Ratings, headquartered in both New York and London, is an award-winning international credit rating agency. It ranks among the '"Big
• Rising StarRising StarA Rising Star is a business or a company that is relatively new to the debt capital markets, with little or no history of debt repayment, which makes it difficult to assess its creditworthiness. Despite the lack of history, the company's performance is strong enough to attract a certain group of investors.