Just the name "high-yield bonds" makes them sound like attractive investments. However, these same bonds are also sometimes called junk bonds, which is a reminder of the risks they entail.
Balancing the return opportunity of high-yield bonds with an understanding of their risks is key to making this kind of investment successfully.
This article can help you navigate both the opportunities and the risks involved with high-yield bond investing by exploring these topics:
- What are high-yield bonds?
- Two types of high-yield bonds - corporate and municipal bonds
- What yield spreads are and why they are important
- High-yield bond opportunities and risks
- How to invest in high-yield bonds
What Are High-Yield Bonds?
The yield on a bond is a function of the interest it pays and its current price as compared to the principal the bond will pay when it matures.
As the name suggests, a high-yield bond is one with a higher yield than most other bonds. However, the reason some bonds yield more than others has to do with their quality.
Bond issuers are evaluated for their creditworthiness much the way individual consumers are given a credit score. There are three major bond rating agencies, and they give bonds a range of scores from high to low.
High scores are given to bonds when there is a high probability that the issuer will meet all the future interest and principal payments due on the bond.
Low scores are given to bonds when there is a substantial risk that the bond issuer will default on some or all of those payments.
These bond ratings are broadly divided into two classifications:
- Investment grade
These bonds are considered to be of high-enough quality for mainstream use as investments by institutional investors.
- High yield
These are bonds rated low enough to be considered speculative in nature. They are also sometimes referred to as "non-investment-grade bonds" or "junk bonds."
Investors will only accept low quality bonds if they are priced low enough to pay high yields. Thus, the high yield on these bonds comes because of their lower quality.
Some corporate bonds are issued as high-yield bonds because the low credit quality of their issuers means they won't find a market for their bonds unless they pay high interest rates.
Other bonds may be issued as investment-grade bonds but get downgraded to high-yield status because of deteriorating financial health. This kind of downgrade will almost certainly be accompanied by falling market prices for these bonds.
Two common issuers of bonds are corporations and state or local governments.
High-Yield Corporate Bonds
Two keys to the quality of corporate bonds are their cash flow and financial obligations.
As far as cash flow is concerned, investors look to see if a company's operations are regularly generating enough cash over and above expenses to meet the interest and principal payments due on its bonds. Having cash reserves is also a plus, but since those reserves may be used for other purposes, having strong cash flow is crucial for a company to be able to meet its debt obligations sustainably.
The amount and priority of those financial obligations is also a factor in the quality of corporate bonds. The more debt a company takes on, either by borrowing or issuing bonds, the more stretched it will be to meet all its payments.
In particular, bond buyers should be aware of whether or not particular bonds are issued as subordinate to other bonds. Subordinate bonds have a lower claim on a company's assets than other bonds should the company fall into bankruptcy. This lower claim means subordinate debt is typically given a lower quality rating.
High-Yield Municipal Bonds
States and local governments issue bonds called municipal bonds. Investors with taxable accounts appreciate municipal bonds because they have certain tax advantages. Their interest is often exempt from income tax federally and for the state in which the bond was issued.
Interest and principal on municipal bonds is paid out of taxes and other revenues the issuer generates. Even though governments are not subject to the same business pressures as corporate bond issuers, the quality of their bonds can still be impacted by economic developments.
For example, a weak economy that results in slower consumer activity could result in less sales tax revenue. A weak real estate market could result in lower property values and thus lower real estate tax receipts.
When considering high-yield municipal bonds, one thing to be aware of is whether they are general obligation or revenue bonds. The basic difference between general obligation bonds and revenue bonds is:
- General obligation bonds represent a claim on any of the municipality's tax receipts or other revenue sources.
- Revenue bonds are a claim on the revenue from a particular project, such as a toll road.
General obligation bonds are usually deemed to be of higher quality than revenue bonds. Because they represent a claim on all the municipality's revenue sources, the bond owner has more ways of getting paid. With revenue bonds, trouble with the project funding the bond could put payment in jeopardy.
Naturally, investors demand a higher yield from low-quality bonds than from high-quality bonds. A key question for high-yield-bond investors is how much extra yield they are getting.
This extra yield is measured by something called the yield spread. The yield spread represents the difference between the yield on a non-investment-grade bond and the yield on an alternative with higher quality.
Yield spreads fluctuate between being wider or narrower over time. When the economy is weak, interest and principal payments on low-quality bonds are at higher risk, so yield spreads tend to widen. In a stronger economy, even riskier bonds have a decent chance of having their payments met - so yield spreads tend to be more narrow.
High-Yield Bond Return Opportunities
Yield spread is a major factor in determining the return on high-yield bonds. The tricky part for investors is that these spreads can vary greatly over time. Those changes in high-yield bond spreads also represent opportunity.
According to the Federal Reserve Bank of St. Louis, historically, the spread between high-yield bonds and US Treasuries has sometimes gone higher than 10% at times such as during recessions, when high-yield bonds have been especially risky.
In contrast, when the economy has been very strong, that yield spread has dipped below 3%.
Investors can profit from those periods of wide yield spread in two ways:
- First, at times like that, the yield alone would represent a very good rate of return.
- Second, since yields on bonds with lower quality have the furthest to fall as the economy improves, that means those bond prices would have the most to gain when that happens.
The opportunity that high-yield bonds represent should be balanced against the risks involved, as described below.
High-Yield Bond Risks
Of course, high yields come with some significant risks. Here are some risks involved with high-yield bond investing:
This is the risk that a bond issuer fails to make all of the interest and principal payments due on a bond. Lower quality bonds have high yields because investors recognize that this is a very real possibility.
Widening yield spread
Even if a bond doesn't default, its price can go down if investors and bond rating agencies feel its financial condition has gotten worse.
In this case, the yield spread would get wider and the price of the bond would go down.
Interest rate risk
If interest rates in the overall economy rise, it tends to push bond prices lower.
The further off the maturity date of a bond, the more time there is for something to go wrong. This includes all of the risks listed above.
With bonds that are already considered high risk because of their financial condition, relying on them to meet their bond payments for many years to come may be very chancy.
High-Yield Bonds ETFs and Other Funds
You can invest in high-yield bonds through exchange-traded funds (ETFs), ordinary mutual funds or other commingled vehicles.
A fund approach gives you the advantage of diversification, which can be especially important when you are dealing with bond issuers that are in shaky financial condition.
However, because of management fees and operating expenses, funds add another layer of cost that will eat into your return - or perhaps wipe it out altogether.
Also, trading activity in the fund may prevent the fund from earning the full yield that a bondholder would get by holding a bond to maturity.
Investing in High-Yield Bonds
What all of this means in terms of when to buy bonds, a potential opportunity is when the economy in general or the outlook for a particular company is improving, but this improvement has not yet been reflected in a more narrow yield spread.
Depending on the nature of the opportunity, you can buy either individual high-yield bonds or invest in a high-yield bonds ETF or other fund specializing in high-yield bonds.
Individual high-yield bonds can be purchased through an online broker. Bond funds can be bought through an online broker or directly from a mutual fund company. Bond funds may also be part of the asset allocation put together by a robo advisor.
Because of their risky nature, high-yield bonds may be appropriate only as a relatively small portion of your portfolio, in combination with less risky investments.
High-yield bonds represent a trade-off between investments that offer higher yields and accepting greater risk. How you assess that trade-off will go a long way toward determining whether your high-yield bond investments are successful.