There is a real allure to a high return on investment. Endless television hours and Reddit threads are dedicated to the hottest performing stock or the high-flying asset class of the hour.
Although you won’t see them on the front pages as often as cryptocurrency or stock, high-yield bonds offer an opportunity to potentially earn a higher rate of return than investment-grade bonds.
But that higher chance at return comes with some corresponding risk.
All investments fall somewhere along the spectrum of risk and reward. That’s simply the nature of investing. In order to increase the chance at a higher reward, an investor must generally increase risk, and vice versa.
High-yield bonds are no exception and have a higher likelihood of default than investment-grade bonds. Sometimes, they are called “junk bonds.”
High-yield bonds are issued by corporations that fail to achieve the credit rating of more stable companies. Or, they’ve had their credit ratings downgraded.
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.
Understanding Bonds
To understand high-yield bonds, it helps to first have a good grasp of bonds in general.
Bonds are popular with investors for being mostly lower risk than stocks. With bonds, that lower risk comes in the form of reduced price volatility and a more predictable yield.
Bonds make up a wide asset class that are essentially investments in the debt of a government—federal or local—or a corporation. They could also be things like mortgages or auto loans.
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.
Government bonds come in several varieties. Bonds issued by the U.S. federal government are often called Treasury bonds, or Treasurys. Bonds issued by state or city governments are called municipal bonds.
Corporate bonds are issued by corporations. Whether a bond is issued by a government or a corporation, they are doing so to raise money for some purpose—just like if you were to take out a loan.
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. The investor acts as the bank in this transaction, making a loan in order to earn a stated rate of interest on that loan.
You may hear the interest rate on a bond referred to as the coupon rate. Most bonds make interest payments—coupon payments—twice annually. In the precomputer days, bonds were physical pieces of paper that had coupons that you’d actually rip off and exchange for your payment, hence the name.
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.
Compare this to shares of common stock, where even the dividend payment is not guaranteed. This is not to say that you can’t lose money investing in bonds. 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 retreat in an environment of rising interest rates—this is called interest rate risk. Here’s a simplified version of how this happens: Say that all bonds issued in a given year are paying 3% annually.
Then, as interest rates rise over the following year, all new bonds are issued at a 4% annual rate. This may cause investors to sell their 3% bonds and buy into the new 4% bonds instead. This decrease in demand in the 3% bonds may cause the underlying price to drop.
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.
High-yield bonds are corporate bonds that were either issued as high-yield bonds by companies looking to raise capital or are the bonds of “fallen angels.” Fallen angels are companies that have been downgraded from a higher credit rating.
In addition to classifications by type (corporate, Treasury, and municipal bonds), bonds are graded on their riskiness, which is also known as their creditworthiness. 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. Treasury bonds and corporate bonds issued by large, stable companies are considered very safe and highly unlikely to default. These bonds come with a AAA rating.
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).
The trade-off is that these “safer” investments typically tend to have a lower yield. Remember, risk and reward are two sides of the same coin. Therefore, bonds with lower credit ratings generally must offer higher coupon rates. Otherwise, no one would ever invest in these bonds.
Pros and Cons of High-Yield Bonds
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
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, which is not required to pay a dividend and whose return on investment via capital appreciation is not guaranteed.
3. Bondholders have priority when a 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 could appreciate due to increased 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
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 the companies that may struggle through hard times.
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 could depreciate due to fallen 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 Bonds
With all bond types, there are two primary ways to invest: by owning the bonds directly and by owning a pool of bonds through the use of bond funds.
By owning bonds directly, you have more control over how your portfolio is invested, but it can be difficult to make changes.
Investing in funds, on the other hand, may allow you to diversify your bond holdings quickly and easily.
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.
To buy bond funds, you can start by opening an account through a financial services firm, like SoFi. No matter your investing preference, SoFi Invest® has an option for you.
With SoFi active investing, investors can buy and sell bond exchange-traded funds (ETFs) and other securities, like stocks and stock ETFs. And there are never any transaction or trading fees to buy funds.
For investors that prefer a hands-off approach, SoFi automated investing may be the right fit. Using a person’s goals and risk tolerance as a guide, SoFi builds and maintains portfolios of ETFs.
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