“High-yield” for investors is often just a polite way of saying “junk.” High-yield often is used in reference to the percentage of interest an investor in high-yield bonds or bond funds will receive. “Junk”, on the other hand, more often refers to the quality of the bond, which means that in exchange for the high-yield the investor will have to accept some additional risk.
But the two terms are ultimately referring to the same thing. Junk was a more popular term in decades past, while today we more commonly see the term high yield used. If you are considering investing in high-yield bonds, you need to know the risks as well as the potential rewards that come with these securities. You see, high-yield bonds generally have low ratings, and pay more interest, than other bonds because the bond issuer’s ability to pay the interest and return the principal is in question.
High-Yield Bonds: Risks and Benefits
Investing in high-yield means a willingness on the part of the investor to take a chance that the bond issuer might fail to make the interest payments, or possibly fail to return the bonds principal upon maturity. Failure to do so is known as a default.
In some cases, new issue bonds are issued as high-yield. The issuing entity needs to raise capital, but because its credit rating is not very good, it is forced to issue bonds with above market rate yields. It’s kind of like a person with bad credit who can only get a credit card that charges 24.99% interest for a revolving balance. But some bonds are not issued as high yield, but become high yield. This occurs when a formerly investment grade bond issuer hits a rough patch which hurts its credit rating.
A lowered credit rating may cause the value of the bond to decline. And when a bonds value declines, its yield rises. And when that happens, we know that we have to look a little deeper into the company’s finances. And to help us with that we have the ratings agencies.
The “Big Three” of ratings agencies are Standard & Poor’s, Fitch and Moody’s. The best rating for a bond by Standard & Poor’s is AAA, or “Triple A”. Very few companies carry a Triple A rating, but anything above a BBB rating from Standard & Poor’s is considered investment grade, which is good, while anything BBB or lower is considered high yield.
And investing in individual high-yield bonds can be quite risky, so for the novice investor the better option may be a high-yield bond fund or ETF. Because like most bond funds, high-yield bond funds tend to be diversified among dozens of different bonds. Diversifying in this way reduces the impact of a potential default.
You see, if there are 50 bonds in the fund, and one of them goes belly-up, the impact on the fund, and the investor, will be minimized. But if the bond that defaults is one of only five bonds in the investor’s portfolio it could have devastating repercussions.
High-Yield Bonds: Final Thoughts
Investing in high-yield can be risky, but it can also be a valuable and rewarding practice. And almost every investor should have a portion of their fixed income portfolio in high-yield bonds. However, because of the risk, most investors should use high-yield bond funds or ETFs.
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