September 19

High Yield Bonds Pros and Cons – What Are They?

Last Updated on 19 September, 2022 by Samuelsson

What are High Yield Bonds?

If you can tolerate high risks, high-yield bonds might be an investment instrument to give a try. But you might first want to know what high-yield bonds are, their pros, and their cons.

High-yield bonds are bonds that pay higher coupon rates because they have lower credit ratings than investment-grade bonds. One major pro of high-yield bonds is their potential for high returns. However, the high returns come at the risk of payment defaults, as the companies that offer them may not be in a good financial state.

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

  • What is a high-yield bond?
  • How high-yield bonds work
  • Are high-yield bonds a good investment?
  • How much do high-yield bonds return?
  • Are high-yield bonds high risk?
  • High-yield bonds rating
  • High-yield bond and inflation
  • Summarizing the pros and cons of high-yield bonds

What is a high-yield bond?

Generally, some bonds are considered “high-yield bonds” because they offer higher interest payments to investors. Many of such bonds are described as “non-investment grade bonds” because they come with higher risk than other bonds.

Thus, high-yield bonds (also non-investment-grade bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. They are corporate debt securities that pay higher interest rates because they have lower credit ratings than investment-grade bonds. These bonds have credit ratings below BBB- from S&P, or below Baa3 from Moody’s. Such bonds are more likely to default, which is why they must pay a higher yield than investment-grade bonds to compensate investors.

Most times, issuers of high-yield bonds are bonds from startup companies or capital-intensive firms with high debt ratios, but they can also be from investment-grade companies that lost their good credit ratings. Since high-yield bonds are risky compared to other bonds, they compensate investors for the additional risk by offering the prospect of greater returns.

How high-yield bonds work

All bonds are characterized according to this credit quality and therefore fall into one of two bond categories — high-yield and investment grade. High-yield bonds are corporate bonds that offer high returns to entice investors.

As you already know, companies issue bonds to borrow money directly from the investing public, which comes at a lower cost than taking bank loans. While blue-chip companies can afford to offer bonds at a relatively low yield and have investors scrambling for them due to their relatively low-risk tag, companies that don’t get up to investment-grade ratings have to offer higher yields to entice investors (kind of compensate them for the higher risk they are taking buying their bonds).

Most of the companies that offer high-yield bonds are startup companies, capital-intensive firms with high debt ratios, or investment-grade companies that lost their good credit ratings. So, technically, high-yield bonds are more or less the same as regular corporate bonds since they both represent debt issued by a firm with the promise to pay interest and return the principal at maturity. However, they differ in the issuers’ poorer credit quality.

Thus, high-yield bonds carry lower credit ratings from the leading credit agencies. Technically, a corporate bond is considered speculative and will thus have a higher yield if its S&P rating is below “BBB or its Moody’s rating is below “Baa3”. Credit ratings can be as low as “D”, which indicates that the companies that are currently in default. Generally, most bonds with “C” ratings or lower carry a high risk of default.

Typically, high-yield bonds are from companies that can be classified into two sub-categories:

Rising Stars: These companies are just starting out, so, generally, they may not be in good financial standing. They are growth companies that are looking for funds to expand their projects and may not be profitable at that time. While these companies may not be rated investment grade at the moment, their ratings may rise in the future.

Fallen Angels: These are companies that were once investment grade but have since been reduced to non-investment bond status because of their current financial status.

Are high-yield bonds a good investment?

Well, we can’t say that high-yield bonds are good or bad investments. Although, high yield bonds have a credit rating below investment grade — below S&P’s BBB, for example — the higher yield is compensation for the greater risk associated with a lower credit rating. So, while it may be suitable for investors with a high risk appetite, it may not be suitable for those conservative investors who are risk averse.

These bonds are often called high-yield corporate bonds, and some of them may be an excellent option for investors seeking high returns. It’s important to know that just because a bond issuer is currently rated at lower than investment-grade counterparts doesn’t mean the bond will fail. As a matter of fact, many high-yield corporate bonds do not fail to pay their interest and also return the principal at maturity.

Given that some of the companies behind these bonds are rising stars, they may end up being more profitable than their investment-grade counterparts and thus can easily pay back much higher returns. But it all depends on the company — all high-yield bonds are not the same.

Another thing to consider is that although these bonds are considered riskier than other bonds, they may still be more stable than (not as volatile as) stocks. In other words, they are somewhere in the middle of a scale between the traditionally higher-return and higher-risk stock market, and the more stable lower-return, lower-risk bond market.

Since no stock or bond is guaranteed to bring returns without some form of risk, it all comes down to the investors choosing what to risk their money on. Nonetheless, given that high-yield bonds are riskier than traditional bonds, you should consider the specific circumstances of the company issuing them. You should investigate the bonds and weigh the pros and cons of each issuer against each other to determine whether or not a particular high-yield corporate bond is a good investment for you. Alternatively, you can invest in high-yield bond ETFs to even out the risks while earning the accompanying huge returns.

How much do high-yield bonds return?

Over the years, high-yield bonds have been known to offer double-digit returns most of the time. In 2009, for example, the returns were as high as 54.22% according to data from the Salomon Smith Barney High Yield Composite Index and the Credit Suisse High Yield Index (DHY). The return was 27.94% in 2003. However, some years also made negative returns — for example, it returned -26.17% in 2008 and -1.53% in 2002.

As with most other investment vehicles, the down years for high yield occurred when there were economic slowdowns, as was the case in 1980, 1990, 1994, and 2000, and most specifically, during the financial crises in 2002 and 2008.

Another thing to note is that yields were much higher in the past than they are today. For example, absolute yields spent much of the 2012–2013 period below 7.5% (even going as low as 5.2% in April and May 2013), which were too low compared to the previous years. The 1980–1990 period generally saw yields in the mid-teens, and even during the lows of the late 1990s, high-yield bonds still yielded 8% to 9%. In the period between 2004 and 2007 interval, yields hovered between 7.5% to 8%, which were record lows at the time. Basically, high-yield bonds paid a much higher yield on average in the past than they do now.

Are high-yield bonds high risk?

Yes. According to data from the S&P High-Yield Bond Index, which tracks the performance of U.S. dollar-denominated, high-yield corporate bonds issued by companies whose country of risk use official G-10 currencies (excluding those countries that are members of the United Nations Eastern European Group (EEG)), high yield bond performance is more highly correlated with stock market performance than is the case with higher-quality bonds.

So, their risk level is closer to those of stocks than those of traditional bonds. High-yield bonds tend to perform better when there is an economic boom than when there is a slowdown in the economy. Here is how: when the economy slows down, profits tend to decline, which affects the ability of high yield bond issuers (generally) to make interest and principal payments. This leads to declining prices on high-yield bonds. Similarly, declining profits also tend to depress stock prices, which is why stocks and high yield bonds move in the same direction most of the time.

To be specific, high-yield bonds face higher default rates and more volatility than investment-grade bonds. This is because the companies that issue such bonds may not be financially stable enough to pay their interest and the principal in due time. Also, while their risk level tends to correlate with that of stocks, high-yield bonds tend to have more interest rate risk than stocks.

To reduce risks associated with high-yield bonds, you can invest in high-yield bond ETFs. This allows you to even out the risks while earning huge returns.

High-yield bonds rating

Generally, high-yield bonds are rated Ba1/BB+ and lower by popular rating agencies such as Moody’s, Standard & Poor’s, and Fitch.

Those agencies research the financial health of each bond issuer and assign ratings to the bonds being offered. Each agency has a similar hierarchy to help investors assess that bond’s credit quality compared to other bonds. Bonds with a rating below BBB- (on the Standard & Poor’s and Fitch scale) or Baa3 (on Moody’s) — that is, from Ba1/BB+ down — are considered “speculative” and often referred to as “high-yield” or “junk” bonds.

Source: Fidelity

High-yield bond and inflation

Inflation generally affects bond prices and yield — as the inflation rate goes up, bond prices will go down. While they are less sensitive to short-term rates, junk bonds closely follow long-term interest rates. However, experts often believe that it would take a recession to plunge high-yield bonds into disarray.

In the present inflation level (over 7% in March 2022), many experts still think that US high yield corporate bonds are likely to face only a modest downside from prospective impacts of input-cost inflation and shortages on credit fundamentals, but some advantages can be gained from careful industry weighting and credit selection.

Summarizing the pros and cons of high-yield bonds

As with any other investment vehicle, there are advantages and disadvantages. The advantages include the following:

  • Higher yields: These bonds generally offer higher yields than investment-grade counterparts. But in actual practice, the gain over investment-grade bonds may not be that much because there will be more defaults. Other ways to play it include high-yield bond mutual funds and exchange-traded funds (ETFs) which allow you to benefit from the higher yields without the undue risk of investing in one junk bond that defaults.
  • Higher expected returns: Of course, these bonds offer higher returns than investment-grade bonds over most long holding periods. For example, between the beginning of 2010 and the end of 2019, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) had an average annual total return of 6.44%, while the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) returned an average of 5.93% per year. So, investors are compensated for higher risk with higher expected returns.

Of course, there are many disadvantages to investing in high-yield bonds. The disadvantages of high-yield bonds are as follows:

  • High default risk: Default is the most significant risk for high-yield bond investors. The possibility of default makes individual bonds too risky in the high-yield bond market. Thus, small investors should generally avoid buying individual high-yield bonds directly, given the high default risk. High-yield bond ETFs and mutual funds are usually considered better choices for retail investors interested in the high-yield bond market.
  • Higher interest rate risk: Another disadvantage of high-yield investing is that yields get eroded when there is a weak economy and rising interest rates. As interest rates go up, bond prices will go down. While high-yield bonds are less sensitive to short-term rates, they closely follow long-term interest rates.
  • Higher volatility: High-yield bond prices tend to be much more volatile than their investment-grade counterparts. The volatility of high-yield bonds tends to follow the stock market more closely than the investment-grade bond market.

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