Pros & Cons of High-Yield Bonds

May 04, 2021 · 8 minute read

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Pros & Cons of High-Yield Bonds

A high-yield bond is debt issued by a corporation that has failed to achieve the credit rating of more stable companies.

All investments fall somewhere along the spectrum of risk and reward. In order to increase the chance at a higher reward, an investor must generally increase risk. High-yield bonds are no exception and have a higher likelihood of default than investment-grade bonds. They are also often called “junk bonds.”

Although you may not see them on the front pages as often as cryptocurrencies or stocks, high-yield bonds offer an opportunity to potentially earn a higher rate of return than investment-grade bonds.

This might bring up many questions for you: What is a high-yield bond? What are high-yield bond rates? Do high-yield bonds make sense for my investment portfolio? It’s important to start at the beginning.

Overview of Bond Market

Bonds are popular with investors for being mostly lower risk than stocks. Bonds make up a wide asset class that are essentially investments in the debt of a government—federal or local—or a corporation.

They are packaged as a contract between the issuer (the borrower) and the lender (the investor). With bonds, you are acting as both the lender and the investor. That’s why bonds are also referred to as debt instruments.

The rate of return that an investor makes on a bond is the rate of interest the issuer pays on their debt plus the increase in value when the bond is sold from when it was purchased. You may hear the interest rate on a bond referred to as the coupon rate. Most bonds make interest payments—coupon payments—twice annually.

You’ll also hear bonds commonly referred to as fixed-income investments. That’s because the interest on a bond is predetermined and will not change, even as markets fluctuate. For example, if a 20-year bond is issued with a 3% interest rate, that interest rate is set and will not change throughout the life of that bond.

Although the interest rate on the bond does not change, the underlying price of the bond can change. Therefore, it is possible to experience negative returns with a bond investment. Bond prices may also retreat in an environment of rising interest rates—this is called interest rate risk.

What Is a High-Yield Bond?

As you might expect, high-yield bonds are bonds that pay a high relative rate of interest. Why might a bond pay a higher rate of interest? Most commonly, because there is a higher degree of risk associated with the bond.

The trade-off is that “safer” bond investments typically tend to have a lower yield. Therefore, bonds with lower credit ratings generally must offer higher coupon rates.

In addition to classifications by type (corporate, Treasury, and municipal bonds), bonds are graded on their riskiness, which is also known as their creditworthiness.

A default can occur when the issuer is unable to make timely payments or stops making payments for whatever reason. In some cases of default, the principal—the amount initially invested—cannot be repaid to the lender (i.e., the investor).

Credit Rating Agencies and Junk Bonds

There are two main credit-rating agencies, S&P Global Ratings and Moody’s.

Each has its own grading system. The S&P rating system, for example, begins at AAA, which is the best rating, and then AA, A, BBB, and so on, down to D. Bonds that are ranked as a D are currently in default and C grades are at a high risk of default.

Using S&P’s system, high-yield bonds are generally classified as below a BBB rating. These bonds are considered to be highly speculative. Bonds at a BBB rating and above are less speculative and sometimes referred to as “investment grade.” With Moody’s rating, high-yield bonds are classified at a Baa rating and below.

This means that bonds with better credit ratings are generally the ones that are least likely to default. Treasurys and corporate bonds issued by large, stable companies are considered very safe and highly unlikely to default. These bonds come with a AAA rating.

Fallen Angels in Bond Market

Fallen angels are companies that have been downgraded from a higher investment-grade credit rating to junk-bond status.

Diminished finances as well as a tough economic environment could send a company from the coveted investment-graded status to junk. For instance, during the Covid-19 pandemic in 2020, the U.S. corporate debt market saw a record $250 billion in fallen angels because of downgrades.

Rising Stars in Bond Market

A rising star is a junk bond that has potential to become investment grade due to an improved financial position by the company. A rising star could also be a company that’s relatively new to the corporate debt market and therefore has no history of debt. However, analysts at credit-rating firms may judge that the company has high creditworthiness due to its finances or competitive edge.

Junk Bonds Pros & Cons

It’s up to each investor to decide if high-yield bonds have a place in their portfolio. Here are the pros and cons of high-yield bonds so you can make a decision about whether to integrate them into your overall investment strategy.

Pros of High-Yield Bonds

1. Higher Yield: High-yield bond rates tend to be higher than the rates for investment-grade bonds. The interest rate spread may vary over time, but high-yield bonds having higher rates will generally be true or else no investor would choose a higher-risk bond over a lower-risk bond with the same rate.

2. Consistent Yield: Even most high-yield or junk bonds agree to a yield that is fixed and therefore, predictable. Yes, the risk of default is higher than with an investment-grade bond, but a high-yield bond is not necessarily destined to default. A high-yield bond may provide a more consistent yield than a stock.

3. Bondholders Get Priority When Company Fails: If a company collapses, both stockholders and bondholders are at risk of losing their investments. In the event that assets are liquidated, bondholders are first in line to be paid out and stockholders come next. In this way, a high-yield bond could be considered safer than a stock for the same company.

4. Bond Price May Appreciate Due To Credit Rating: When a bond has a less than perfect rating, it has the opportunity to improve. This is not the case for AAA bonds. If a company gets an improved rating from one of the agencies, it’s possible that the price of the bond may appreciate.

5. Less Interest-Rate Sensitivity: According to the bond investing outlet, PIMCO, high-yield bonds may actually be less sensitive to changes in interest rates because they often have shorter durations. Many high-yield bonds have 10-year, or shorter, terms, which make them less prone to interest rate risk than bonds with maturities of 20 or 30 years.

Cons of High-Yield Bonds

1. Higher Default Rates: High-yield bonds offer a higher rate of return because they have a higher risk of default than investment-grade bonds. During a default, it is possible for an investor to lose all money, including the principal amount invested. Unstable companies are particularly vulnerable to collapse, especially during a recession. The rating agencies seek to identify these companies.

2. Hard to Sell: If an investor invests directly in high-yield bonds, they may be more difficult to resell. In general, bond trading is not as fluid as stock trading, and high-yield bonds may attract less demand or have smaller markets, and therefore, may be harder to sell at the desired price, or at all.

3. Bond Price May Depreciate Due to Credit Rating: Just as a bond price could increase with an improved rating, a bond price could fall with a decreased rating. Investors may want to investigate which companies are at risk of a lowered credit rating by one of the major agencies.

4. Sensitive to Interest Rate Changes: All bonds are subject to interest rate risk. Bond prices move in an inverse direction to interest rates; they can decrease in value during periods of increasing interest rates.

How to Invest in High-Yield Bonds

There are two primary ways to invest in junk bonds: by owning the bonds directly and by owning a pool of bonds through the use of mutual funds or exchange-traded funds (ETFs).

By owning high-yield bonds directly, you have more control over how your portfolio is invested, but it can be difficult for retail investors to do this. Brokerage firms typically allow sophisticated investors to directly own junk bonds, but even then it could be labor-intensive and a hassle.

Investing in high-yield bond mutual funds or ETFs, on the other hand, may allow you to diversify your holdings quickly and easily.

Junk-bond funds may also allow you to make swift changes to your overall portfolio when needed; they might be more economical for smaller investors; and they allow you to invest in multiple bond funds if desired. It’s important to check both the transaction costs and the internal management fee, called an expense ratio, on your funds.

The Takeaway

The junk bond market can represent a happy medium for investors looking for a safer investment with higher returns. While companies that issue high-yield bonds tend to be lower on a scale of creditworthiness than their investment-grade counterparts, junk bonds still tend to have more reliable returns than stocks or nascent markets like cryptocurrencies.

To buy high-yield ETFs, you can start by opening an account with SoFi Invest®. With SoFi Active Investing, investors can buy and sell junk-bond ETFs, as well as trade traditional company stocks and fractional shares. They can buy and sell these assets without incurring any SoFi commissions.

Stay up to date with the market by downloading the SoFi app.

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