There are some assets that offer investors a higher return than any other in the market, such as high yield bonds. But, what are high yield bonds and how do they work? Let’s see it below.
- 1 What are high yield bonds?
- 2 How do high yield bonds work?
- 3 High Yield Bond Categories
- 4 Advantages of investing in junk bonds or high yield bonds
- 5 Disadvantages of investing in junk bonds or high yield bonds
- 6 In summary, what are high yield bonds and how do they work?
What are high yield bonds?
High yield bonds or high yield bonds are, as the name implies, bonds that generate a high interest rate for investors. The reason for their profitability is that they have lower credit ratings than the other bonds available in the investment portfolio.
Having a much higher implicit risk than that of classic investment bonds, high yield bonds pay a much higher yield to offset the risk buyers take. The issuers of high-yield debt tend to be start-ups or institutions that, despite have capitaloperate with a high debt ratio.
Note: The issuers of high yield bonds are not always unknown or highly indebted companies. It could also be a group of companies known as “fallen angels”, that is, companies that for whatever reason have lost their good credit ratings.
How do high yield bonds work?
From a technical point of view, high yield bonds or junk bonds are practically the same as a standard corporate bondsince both represent the same thing, that is to say, that a company issues a debt title with the promise of paying the amount invested plus the interest generated to those who acquire it.
In short, if the bond is worth $100, at the end of the term (which is the expiration date of the bond), the company will return the investor’s capital, that is, $100, plus the interest generated. The main difference is that, in essence, the company that issues the junk bond has a worse credit rating than the other companies in the market.
It is important that you keep in mind that all bonds are characterized by having a risk. If the company’s credit rating is high, then the risk is lower and vice versa. This causes bonds to be divided into two classes or types: high yield bonds and investment grade bonds.
high yield bonds have a lower credit rating. Therefore, its price is more speculative or volatile, and therefore, it will have a higher yield than that of a BBB bond. Bonds with ratings equal to or greater than BBB from the S&P Index or Baa3 from Moody’s are considered investment grade bonds.
Now, high-yield bonds can be issued by companies with ratings as low as “D” (ie, already in default), although they are mostly from “C”-rated companies.
High Yield Bond Categories
We could say that junk bonds are divided into two subcategories: Fallen Angels, which are bonds that once had a good investment rating, but have been downgraded because the issuing company does not have the same credibility or credit quality; and the Rising Starswhich are just the opposite, that is, companies that have improved their credit quality.
Advantages of investing in junk bonds or high yield bonds
There are two main advantages to junk or high yield bonds, one of which is, of course, the degree of performance and the second is that it offers a higher return of the expected. Let’s see what this is about:
Investors in junk bonds can generally expect a return so high that they could reach 150 points and even exceed 300 basic performance pointsthis if compared to the investment grade bonds. In actual practice, the profit you could make with these bonds is higher than the first because there is a high risk of default.. Mutual funds and Exchange Traded Funds (ETFs) offer a variety of ways for consumers to “safely” take advantage of this high yield.
Higher return than expected
While high-yield bonds suffer from a negative image, they could actually become a great way to multiply money quickly, especially if bond holding periods are long. For example, the iShares iBoxx High Yield Corporate Bond ETF (known in the financial world as HYG) had an average annual total return of 6.44% from the beginning of 2010 to the end of 2019. During that time, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), meanwhile, returned an average annual return of 5.93%. As you can see, the percentage that represents the yield of the junk bond is much higher than that of other options on the market.
Disadvantages of investing in junk bonds or high yield bonds
Every financial strategy has its counterpart and junk bonds are no exception to this reality. Among the disadvantages of preferring these bonds over others in the market, we have the following:
The default itself is the most significant risk for investors with high yield bonds. The ideal way to deal with this risk is portfolio diversification, but this strategy is often subject to high fees.
Although an investor could buy their bonds and keep them in their possession until the payment date to avoid charging extra fees and commissions, it is not a highly recommended strategy, unless they are an expert investor who knows how to stagger their bonds and investments and thus reduce risks.
Tip: Small investors should move away from buying individual subprime bonds to managing them directly. It is best to opt for a high-yield ETF or a mutual fund.
Historically, the price of high yield bonds has experienced much more volatility than its counterpart. In 2008 alone, high yield bonds lost 26.17% of their market value. Between 1980 and 2020, a diversified portfolio of investment-grade bonds (including corporate and government bonds) only lost 3% on average in a calendar year. As you can see, the volatility of high yield bonds assimilates them to the stock market.
In summary, what are high yield bonds and how do they work?
Before saying goodbye, let’s see a summary of what is exposed in this article:
- High yield bonds or junk bonds are corporate debt securities that pay a much higher interest rate than classic bondsmainly, because they are companies with a lower credit rating.
- These bonds have credit rating below BBB of the S&P Index, or Moody’s Baa3.
- Although high yield bonds offer a much higher return than other investment bonds -which translates into better performance, especially if it is long-term- are subject to a higher level of risk.
- Due to risk and rating, junk bonds -as they have a high probability of default or renegotiation- They are extremely volatile in price.at least when compared to other options in the financial market.