April 7

What is the difference between a junk bond and a high yield bond?

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Last Updated on 7 April, 2022 by Samuelsson

What is the difference between a junk bond and a high yield bond?

 

The terms, ‘junk bonds’ and ‘high-yield bonds’, are often used interchangeably. Do they mean the same thing, or is there a subtle difference between them?

Technically, there is no difference between a junk bond and a high-yield bond. Both are terms used to describe bonds issued by entities with non-investment-grade ratings. However, they differ from investment-grade bonds.

In this post, we will take a look at the following:

  • What do junk bonds and high-yield bonds refer to?
  • What is the difference between investment-grade and high-yield bonds?
  • High-yield bond market size
  • Are high-yield bonds a good investment?
  • High-yield bond rating
  • What happens to high-yield bonds when interest rates rise?
  • What are the advantages and disadvantages of junk bonds?

What do junk bonds and high-yield bonds refer to?

A junk bond, also known as a high-yield bond, is a bond that has been given a low credit rating (below investment grade) by a rating agency because the issuer is not in a good financial state, and as such, the chances of a default are higher. Given the higher risk of default, investors are compensated with higher yields.

Bonds, as you know, are debt instruments with which an issuer agrees to pay investors interest payments along with the return of invested principal at a specified future date. In the case of a junk or high-yield bond, the issuer is not in a good financial state and, therefore, has a high risk of delayed payment or defaulting.

While junk bonds may carry the highest risk of a company missing an interest payment, they are still are less likely than many stocks to generate permanent portfolio losses since a company is obligated to repay bondholders before shareholders if it goes bankrupt. Their high yields may compensate for the high risks.

There are many high-yield bond examples, but consider one: Let’s say a startup named ABC with an S&P rating of BB issues a seven-year bond with a 10% annual coupon rate at $500 per unit. The BB rating means that it is not an investment-grade bond. To compensate, the company offers a high rate (10%). An investor who purchases the bond earns an amazing 12% x $500 ($50) per unit purchased each year until the bond matures in seven years, at which time the investor gets their principal.

What is the difference between investment-grade and high-yield bonds?

All bonds are characterized according to this credit quality and therefore fall into one of two bond categories: high-yield and investment grade. There is a lot of difference between investment-grade bonds and high-yield (speculative grade) bonds. Some of them are as follows:

  • The rating: Investment grade bonds have a rating of BBB- and above on the S&P or Fitch scale, and Baa3 and above on the Moody’s scale. High-yield bonds, on the other hand, have lower ratings: BB+ or below on the S&P or Fitch scale, and Ba1 and below on the Moody’s scale. See the table below for the various ratings for both investment-grade and high-yield bonds.
  • Default risk: Investment-grade bonds are issued by companies that are in a stable financial state, so the risk of default is low. High-grade bonds tend to have a high default risk because the issuers are not in good financial condition.
  • Yield: Investment-grade bonds don’t offer high yields as high-yield bonds do. High-yield bonds use significantly higher yields to compensate investors for taking the higher risks to invest in them.
  • Volatility: While both investment-grade bonds and high-yield bonds do experience volatility, high-yield bonds tend to be much more volatile than their investment-grade counterparts, and their volatility tends to follow the stock market more closely than the investment-grade bond market.

A table comparing investment-grade vs. high-yield bonds

 

Source: Fidelity

High-yield bond market size

According to the high-yield bond issuance data from SIFMA Research, the U.S. high-yield bonds outstanding as of the first quarter of 2021 were estimated to be about $1.7 trillion, which makes up about 16% of the $10.7 trillion U.S. corporate bond market.

The data shows that new issuances amounted to $435 billion in 2020.

Are high-yield bonds a good investment?

High-yield bonds are not intrinsically good or bad investments: it depends on the individual bonds and the investor’s risk appetite. While some junk bonds may be an excellent option for investors seeking high returns, others may be too risky that the high yields can’t compensate for the risk.

However, note that just because a bond issuer is currently rated at lower than investment-grade counterparts doesn’t mean the bond will fail. It is important to investigate the issuing company’s finances first before deciding whether to invest or not. Many junk corporate bonds do not fail to pay their interest and also return the principal at maturity. Moreover, when you consider that some of the companies behind these bonds are rising stars and may end up being more profitable than their investment-grade counterparts, you may want to consider adding them to your portfolio.

If you are concerned about the risk involved in investing in individual high-yield bonds, you can invest in high-yield bonds ETF to even out the risks while earning the accompanying huge returns.

High-yield bond rating

High-yield bonds are usually rated Ba1/BB+ and lower by popular rating agencies such as Moody’s, Standard & Poor’s, and Fitch. The Standard & Poor’s and Fitch rate high-yield bonds BB+ or lower, while Moody’s rate them Ba1 and lower. See the table below for the ratings that fit into the high-yield bond status.

Source: Fidelity

What happens to high-yield bonds when interest rates rise?

When interest rates go up, high-yield bond prices will go down. While these bonds may be less sensitive to short-term rates, they closely follow long-term interest rates. But most times, it may take a recession for these bonds to significantly underperform when interest rates are high.

What are the advantages and disadvantages of junk bonds?

Some of the advantages of junk bonds include:

  • They offer higher yields than most other fixed-income debt securities.
  • They have the potential for significant price increases if the issuing company’s financial situation improves.
  • They serve as a risk indicator, showing when investors are willing to take on risk or avoid risk in the market.

The disadvantages include:

  • High-yield bonds have a higher risk of default than most bonds with better credit ratings.
  • Their prices can exhibit volatility due to uncertainty surrounding the issuer’s financial performance.
  • They are prone to interest rate changes

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