High-yield bonds: High-risk, high-reward

A high-yield or junk bond is a specific type of bond that is accompanied by higher risk in exchange for greater returns. When you buy a bond - any kind of bond - you're essentially giving the issuer (often a government agency or a corporation) a loan, who in turn agrees to pay you back the original value of the loan on a specific date, with periodic interest payments along the way as the incentive for buying the bond in the first place.

Within the umbrella category of "bonds," there are different types that are grouped based on the reliability of the issuer to make good on the deal. As a result, you end up with two general labels for all bonds: investment grade and non-investment grade. The term "high-yield" is simply another name for non-investment grade bonds.

These bonds pay higher interest than investment-grade bonds due to their poor credit ratings. This means that ratings services have deemed these bonds as more likely to default. As compensation for investors willing to take on these lower-graded bonds, high-yield bonds offer higher payments, or yields.

Market analysts sometimes use the junk bond market as a gauge for the state of the economy. If more investors buy them, their willingness to take on risk suggests optimism about the economy. Conversely, suppose investors are shying away from high-yield bonds. In that case, that is a sign that investors are behaving more risk-averse, suggesting a pessimistic view of the current state of the economy. This circumstance may predict either a business cycle contraction or a bear market.

Investment-grade bonds vs. non-investment-grade bonds

Bonds are investments in debt, and not all debts are created equal. Therefore, a grading system is necessary to classify and qualify each bond's "invest-ability."

As a result, agencies evaluate bonds based on their likelihood of being repaid, based on the issuer's financial ability. Unsurprisingly, this produces a fairly wide range of grades that require further stratification.

Investment-grade bonds encompass the highest-rated bonds, while the groups of bonds with poor grades are called non-investment-grade bonds.

Investment-grade bonds

These highly-rated bonds pay relatively low interest because their issuers don't have to pay more. Investors looking for a safe place to put their money will buy them.

Investment-grade bonds carry ratings of Baa (by Moody's) or BBB (by S&P and Fitch) or above, though bonds with those ratings are considered the lowest grade. Non-investment grade bonds have lower credit ratings of Ba and down to C (Moody's) or BB down to D (S&P and Fitch).

Non-investment-grade bonds

Non-investment-grade bonds have higher yields and carry greater risks and lower credit scores than investment-grade bonds. Non-investment-grade bonds are also known as high-yield bonds or junk bonds.

Learn more about investment grade with our in-depth article.

Advantages of high-yield bonds

Higher returns

Investors choose high-yield bonds for their potential for higher returns.

High-yield bonds provide higher yields than investment-grade bonds. Typically, the bonds with the highest risks also have the highest yields, as the issuers of the bonds must reward investors with an incentive to compel them to take on more risk.

Balancing risk in an equities-heavy portfolio

Investors should consider including high-yield debt alongside equities in their investment portfolio. Historically, high-yield drawdowns have been less severe than equity drawdowns, making high-yields a good option for reducing downside risk and diversifying during bear markets. Additionally, equities have historically taken longer to recover from drawdowns.

By reallocating a portion from US equities to US high yield, investors can enhance risk-adjusted returns, reducing volatility without compromising too much potential return.

Drawbacks of high-yield bonds

High-yield bonds carry various risks, including higher volatility, default, interest rate, and liquidity risks. However, they compensate for this by offering investors the potential for higher returns.

Default risk

Default risk is the most significant concern for high-yield bond investors. Diversification is the primary method for managing default risk, but it can limit strategies and increase investor fees.

When individuals invest in investment-grade bonds, they can purchase bonds directly from individual companies or governments. Holding individual bonds allows investors to create bond ladders, which can help reduce interest rate risk. By holding individual bonds, they can avoid the fees associated with bond funds. However, it's important to note that investing in individual bonds carries the risk of default, making it a riskier option than investing in bond funds.

A higher risk of default may lead to smaller self-directed investors preferring to avoid purchasing individual high-yield bonds. Better options include high-yield bond exchange-traded funds (ETFs) and mutual funds, as their diversification helps to mitigate risk.

Interest rate risk

All bonds are subject to interest rate risk, meaning that as interest rates rise, bond prices fall. The longer a bond’s term, the greater the interest rate risk due to the increased potential for changes in interest rates over time.

If interest rates increase, bond prices are likely to fall, as new bonds will have higher returns on the money invested by their investors. However, rising interest rates could be used to encourage high-yielding bonds because interest rates tend to grow in the context of economic expansion, and corporations issuing these bonds should profit more. This would mean they would be less susceptible to default.

With an imminent interest rate rise, perhaps caution could be seen among high-yield investors. But the junk bonds themselves will still retain their nominal properties.

Higher volatility

High-yield bonds are historically quite volatile, on par with the stock market. This differs sharply from investment-grade bonds, which have much lower levels of volatility.

Liquidity risk

Liquid assets can be quickly sold for cash, and bonds with higher liquidity are traded more frequently. Liquidity risk relates to being unable to sell an asset at the right time and for a price reflecting its true value.

What type of investor buys high-yield bonds?

All investors should know that buying high-yield or junk bonds is inherently risky. There is the risk that the issuer will file for bankruptcy, causing the investment to be lost. So naturally, the investors pursuing high-yield bonds tend to have higher risk appetites and overlook apparent drawbacks in pursuing substantial upside.

Start-ups or capital-intensive companies are frequently the issuers of high-yield debt. An investor who perhaps has prior experience dealing with these types of companies would have a greater comfort level due to existing knowledge of what factors to look for in assessing the viability of the investment.

The high-yield bond fund

Investing is often seen as a pursuit exclusively for the wealthy. However, small-time self-directed investors interested in high-yield bonds could consider investing in a high-yield bond fund.

While it still involves higher risk than an investment-grade bond, it can be a sensible option for those seeking higher returns. High-yield bond funds can offset risk by diversifying portfolios across different asset types.

Before purchasing a bond fund, investors should consider the duration they can commit their funds, as many do not allow withdrawals for at least one or two years.

There comes a point when the potential rewards of high-yield investments no longer justify the associated risks. Investors can assess this by comparing the yield spread between junk bonds and U.S. Treasuries. Historically, the yield on junk bonds has been 4% to 6% higher than that on U.S. Treasuries. If the yield spread falls below 4%, conventional wisdom dictates that investing in high-yield bonds is not worth the additional risk.

One more thing to look for is the default rate. This can be tracked on Moody's website. Junk bonds are known to follow boom and bust cycles, similar to stocks. However, a default surge can generate significant negative returns for these funds.

Corporate bonds and credit risk

Corporate bonds are another type of debt instrument issued by a company, distinct from one issued by a government or government agency. This type of investment differs from equities most greatly in that they don't offer any ownership in the company that issued the bond. It is strictly a means of fundraising by the corporation and a means to profit by the investor.

While some corporate bonds contain features that can alter the maturity date, most are loosely categorized into the following maturity ranges:

• Short-term notes (maturities of up to five years)

• Medium-term notes (between five and 12 years)

• Long-term bonds (greater than 12 years)

Why invest in corporate bonds

Corporate bonds can offer a range of potential benefits including, but not limited to:

• Diversification: Corporate bonds offer the opportunity to invest in a variety of economic sectors. Within the broad spectrum of corporates there is a wide divergence of risk and yield. Corporate bonds can add a measure of diversification to an equity portfolio as well as add some differentiation to a fixed income portfolio of government bonds or other fixed income securities.

• Higher yields: Corporates tend to offer higher yields than comparable maturity government bonds.

• Liquidity: Corporate bonds can be flipped at any time prior to the maturity date in a large and active secondary trading market.

Risks of corporate bonds

Similar to government bonds, corporate bonds are subject to interest rate risk. In addition, corporate bonds also have credit or default risk, or the risk that the borrower fails to repay the loan and defaults on its obligation. Of course, the level of default risk varies based on the underlying credit quality of the issuer.

High-yield bonds vs. mutual funds

Bonds and mutual funds can play important roles in a well-diversified investment portfolio, but it's essential to understand the differences when considering high-yield bonds versus mutual funds.

Bonds can provide a regular income and be considered a low-risk investment but may offer lower returns. Of course, this is not the case with high-yield bonds, which are similar to mutual funds in that the latter may offer higher potential returns and risk.

At that point, it will become more dependent on the investor's desire for a mutual fund's diversity instead of the high-yield bond. Spreading the risk between multiple assets could be more attractive, depending on the investor's appetite for introducing additional factors and potential opportunities for downswings into their portfolio.

Where can you buy high-yield bond funds?

High-yield bonds are available at almost any online broker, but specialized brokers might offer more. Bond ETFs can usually be purchased from any top internet broker. You may also want a good broker to help you get what you want. Mutual funds are different. Since no mutual fund has all the options at each broker, you may know what a mutual fund offers you. Get started by searching if the broker offers access to your desired bond funds.