Key Takeaways
- Below investment-grade credit rating bonds.
- Higher yields compensate for greater default risk.
- Shorter maturities and higher income potential.
- Volatile prices influenced by economic conditions.
What is High-Yield Bond?
A high-yield bond, often called a junk bond, is a corporate debt security rated below BBB−/Baa3 by credit agencies, reflecting a higher risk of default compared to investment-grade bonds. These bonds offer elevated coupon rates to compensate investors for taking on this increased credit risk.
Issued by companies with weaker credit profiles, high-yield bonds frequently feature characteristics like callable bond provisions and shorter maturities to attract capital from investors seeking higher income potential.
Key Characteristics
High-yield bonds stand out due to their distinct risk-return profile and structural features:
- Credit Rating: Rated below investment grade, often BB, B, or CCC categories, indicating elevated default risk but greater yield potential.
- Yield: Offer higher coupon rates than investment-grade bonds, providing attractive income especially in low-rate environments.
- Maturity and Call Features: Typically have shorter maturities around 7-10 years and may include callable bond options allowing issuers to redeem early.
- Liquidity: Generally less liquid than higher-rated bonds, increasing trading costs and price volatility; related to illiquid market conditions.
- Duration Sensitivity: Shorter duration than investment-grade bonds, making them less sensitive to interest rate changes but more sensitive to economic cycles.
How It Works
High-yield bonds function by offering investors increased income through higher coupon payments to offset the greater risk of default inherent in lower-rated issuers. You effectively lend capital to companies with weaker credit profiles but potentially higher growth or restructuring prospects.
These bonds respond more to changes in issuer creditworthiness and economic outlook than to interest rate shifts. Their J-curve effect means price appreciation can follow initial volatility, especially during recoveries, rewarding patient investors.
Examples and Use Cases
High-yield bonds are commonly used by companies in sectors with cyclical or capital-intensive operations, where credit risk is elevated but financing is essential.
- Airlines: Delta and American Airlines have issued high-yield bonds during periods of expansion or restructuring to raise capital despite non-investment-grade ratings.
- Dividend Income Strategy: Investors seeking enhanced yield might complement their portfolios with high-yield bonds alongside high-yield dividend stocks to boost income streams.
- Bond Selection: Adding a measured allocation of high-yield bonds to a diversified fixed-income portfolio can improve overall returns and reduce volatility, as supported by research on bond ETFs incorporating high-yield segments.
Important Considerations
When investing in high-yield bonds, understand the balance between higher income and increased credit risk. Defaults are more common than in investment-grade bonds, so thorough credit analysis is essential.
Liquidity constraints and issuer call features can affect returns and reinvestment opportunities. Familiarity with terms like bad credit will help you assess issuer risk and potential volatility in your holdings.
Final Words
High-yield bonds offer attractive income and growth potential but come with increased default risk that requires careful credit analysis. Consider evaluating current yields against your risk tolerance and diversify to balance potential rewards and risks.
Frequently Asked Questions
A high-yield bond, also called a junk bond, is a corporate debt security rated below BBB−/Baa3. These bonds offer higher interest rates to compensate for their increased risk of default compared to investment-grade bonds.
High-yield bonds pay higher coupon rates to compensate investors for the elevated default risk associated with lower credit ratings. They can also provide equity-like total returns through a combination of yield and potential price appreciation.
The primary risk is a higher chance of default, especially during economic downturns when issuers may struggle to make payments. Additionally, these bonds tend to be more volatile, less liquid, and have limited call protection compared to investment-grade bonds.
High-yield bonds often perform well during economic recoveries, benefiting from price appreciation alongside their high yields. Historically, they have shown resilience by limiting losses during volatile periods and outperforming investment-grade bonds in bull markets.
High-yield bonds usually have shorter maturities, often between 7 to 10 years, and may include call provisions that allow issuers to refinance after 4 to 5 years, which can impact reinvestment risk for investors.
Including about 20% high-yield bonds with 80% investment-grade bonds has historically improved risk-adjusted returns, offering higher annualized yields with manageable volatility compared to holding only investment-grade bonds.
Credit risk depends on the issuer's financial health, including leverage ratios, earnings coverage, and overall economic conditions. Companies with weaker balance sheets or in recovery phases tend to have higher default probabilities.
