What are High Yield Bonds?
The term “high yield bonds” refers to those bonds that are rated below the investment grade by the leading credit rating agencies. As such, these bonds are considered to have a higher risk of default as compared to other bonds and hence these bonds offer higher returns to compensate the investors for the higher perceived risk. Such high yield bonds are typically issued by established capital intensive companies with high leverage ratio or new companies that are yet to prove their credentials.
Explanation of High Yield Bonds
High yield bonds are characterized by lower credit ratings from the rating agencies, such as a rating below Baa3 from Moody’s or below BBB- from S&P. Such bonds are considered to be high risk and speculative in nature, and hence are required to offer a higher yield. Historically, high yield bonds exhibit a higher propensity to default as compared to investment-grade bonds. Although most of the high yield bond issuers are either capital intensive firms or startup companies, some of these bonds are issued by fallen angels who lost their good credit ratings over the period of time.
Features of High Yield Bonds
Now, let us look at some of the most common features of high yield bonds:
- These bonds are rated at non-investment grade credit rating.
- As the name clearly suggests, these bonds offer significantly higher yield vis-à-vis the investment grade bonds.
- Most of these bond issuers have the flexibility to defer interest payments in order to improve their cash flow position.
- High yield bonds are usually unsecured debt obligations for the issuers.
- Covenants are put in place in order to restrict the issuers from performing any such activities that are detrimental to the interest of the creditors/ lenders.
How to Buy High Yield Bonds?
The interested investors can either directly invest in these high yield bonds through the broker-dealers or indirectly invest by purchasing shares in exchange-traded funds (ETFs) or mutual funds. These ETFs and mutual funds are the ones that have a portfolio with a greater focus on high yield bonds.
Types of High Yield Bonds
The high yield bonds can be broadly categorized into the following six types:
- Straight cash bonds: These are plain vanilla bonds that offer fixed coupon rate, usually paid semi-annually, up to maturity or early redemption, and are paid out in cash.
- Split-coupon bonds: These bonds offer two different coupon rates in the early and later years of the bond. Split-coupon bonds in which the coupon rates increase in the later years are known as step-up notes.
- Pay-in-kind bonds: The issuers of these bonds have the flexibility to either pay the bondholders in cash or in additional securities.
- Floating-rate notes: The coupon rate of these bonds is linked to a benchmark and hence it fluctuates as the benchmark interest rates change.
- Extendable reset notes: The issuers of these bonds are given the option to reset the coupon rate and extend the bond’s maturity either at a periodic interval or at the occurrence of a specified event. In exchange, the investors hold the right to sell the bonds back to the issuers.
- Deferred-interest bonds: The bond issuers have the flexibility to defer the coupon payment to the bondholders until a future date.
Investment in High Yield Bonds
The trend witnessed in the investment in high yield bonds can be a great indicator for the state of the economy. If investment in high yield bonds is increasing, then it indicates that the investors are willing to take risks which is a sign of optimism in the economy. Conversely, if investment in high yield bonds is declining, then it indicates that the investors have turned risk-averse which is a sign of pessimism in the economy. In this way, trend in investment in high yield bonds may be used to predict both expansion or contraction of the economy.
High Yield Bonds Rates
The below table and chart show how high yield bond rates in the US have varied over the years. It can be seen that the bond rates peaked in 2009 to reach 13.83%, which was during the great recession of 2008-09. After that the bond rates have gradually declined, which is largely driven by the declining treasury bond rates.
|Year||Yield in %|
Source: FRED Economic Data
Who Issues High Yield Bonds?
The high yield bonds are usually issued by established companies that are either characterized by high leverage ratios or are facing financial difficulties. On the other hand, smaller and emerging companies also issue high yield bonds to compensate for their lack of proven track record. Other issuers of high yield bonds include companies whose financial plans are considered to be highly speculative or risky.
Some of the major advantages of high yield bonds are as follows:
- These bonds offer a significantly high spread over treasury securities.
- These securities exhibit a low correlation with other fixed income securities that result in consistent high returns.
- Investors of high yield bonds are paid off ahead of common and preferred shareholders in case of liquidation.
- Given their shorter maturity periods, these bonds help in lowering the overall duration of the portfolio.
Some of the major disadvantages of high yield bonds are as follows:
- During economic stress, these bonds are more prone to defaults as compared to other bonds.
- Given the inherent risks and limited supply, these bonds exhibit low market liquidity, wide bid-ask spread, and high transaction costs.
So, it can be seen that high yield bonds are very attractive as it can generate returns like equities with risks similar to that of bonds. However, it is very important to evaluate the risks vis-à-vis the returns to avoid any kind of value trap.
This is a guide to High Yield Bonds. Here we also discuss the introduction and features of high yield bonds along with advantages and disadvantages. You may also have a look at the following articles to learn more –