The bonds market is one of the most exciting securities markets that offers abundant investment opportunities. The bonds market keeps evolving day by day, and to stay ahead of the game you need to understand all trends related and factors that govern it. If you are someone who is just now delving into the world of bonds and are not sure whether you understand the different concepts and products within it, this article will help you polish your knowledge about high-yield bonds in particular.

What is a bond?

A bond is a loan instrument where the investor acts as the bank. The money is generally loaned to a city, government, or organization that pays the investment back in full with regular interest payments. Bonds are usually sold when the institution needs financing, especially when it is in debt. Bonds are broadly categorized as government bonds, corporate bonds, and emerging market bonds. Various benefits and reasons for which people make investments in bonds include preservation of capital, high income, appreciation of capital, diversification of investment portfolios, and hedging against possible deflation.

Nervous investors often flock to the safety that bonds offer, in the form of a steady stream of income. However, this does not mean that all bonds are risk-free; in fact, it is quite the opposite. Just like with any other investment avenue, you will be rewarded more for buying a riskier investment product.

What is a high yield bond?

According to Standard & Poor’s (S&P), Moody’s and Fitch, ‘High-yield bonds, also referred to as “junk bonds”, are debt securities issued by companies deemed too risky to be assigned an investment-grade credit rating by any of the major rating agencies.

These bonds are not considered for an investment-grade rating owing to the higher risk of default. A default occurs when the organization that issues the bond does not repay the principal or the interest on time. These junk bonds are usually offered to get out of bad debts. Since these institutions offering bonds are already facing financial difficulties, they pose a high risk of defaulting; but despite that, they offer high-interest rates to attract investors. These bonds may be offered by both young as well as established companies to offset unproven operating histories or because of risky financial planning.

Delving into high yield bonds

High yield bonds are a subcategory of corporate bonds. Corporate bonds are sub-categorized as investment grade and speculative grade, also known as high yield bonds. A bond is classified as a high yield or junk bond based on the credit rating. A credit rating simply refers to the ability of the issuer to pay back the principal and interest as per the decided schedule. The ones that hold a bad credit rating are rated as below investment grade. This credit rating is given by individual credit rating agencies.

The term ‘junk bonds’ has been a disservice to this category of bonds as the asset class gained a negative connotation owing to this labeling in the initial years. The non-investment grade bonds market emerged sometime in the 1970s and was characterized by companies that issued them to get out of crippling debt. These ‘fallen angel’s’ defaulted and did not prove to be so lucrative to investors until the 1980s, when the market boomed. This was when high yield bonds became an important tool for leveraging buyouts and mergers. However, now the high yields bonds marketplace is quite popular and is a hotbed of investors and issuers.

In some cases, private companies and other institutions issue bonds with high-interest rates when they need to raise capital but cannot do so because of bad credit rating. In many cases, these institutions would have formerly issued investment-grade bonds as well, when their financials were in good shape. However, the purpose for which high yield bonds are issued is diversifying as companies now resort to these instruments even when they are not in terrible shape financially. Today, investors can buy these bonds from companies who are plainly issuing them to meet capital needs or consolidating and paying credit to banks. In the current scenario, you can find companies across all stages of the establishment issuing these junk bonds.

Nature of risks

Since there is a good chance that the investor may not get back what he has invested, it is better for individual investors, especially novices, to stay away from it. Although, it is not so risky for this category of investors to buy high yield bonds through mutual funds or any other diversified portfolios. In such a case, the analysis starts with an overview of the high yield bond market and studying the dynamics of spreads, its unique risk characteristics, and size. After this, such instruments will be evaluated in terms of their possible role in a diversified portfolio, with particular focus on the market characteristics and challenges that come with adding them into an investment strategy.

The issuance of new high yield bonds each year depends a lot on the market as well. If the market seems to be doing well and if the investors are seeing a more encouraging environment, there is a good chance that bonds at higher rates will be issued. A prediction of recession in the near future also affects the new issuance of high yield bonds.

A direct way of investing in high yield bonds is buying them from brokers. Another way of investing in the same is through mutual funds or exchange-traded funds (ETFs) that have portfolios in high yield bonds.

Risks of investing in high yield bonds

The main risks associated with high-yield bonds are as follows:

• Credit risk

Also referred to as default risk, this is a key risk associated with high-yield bonds. An already staggering financial condition of the institution issuing the bonds increases the chances of investors losing their money. An event of default can be defined as the failure of the company to meet any terms of the debt agreement. A company’s inability to hold itself strong amid challenging economic circumstances increases its credit risk.

• Economic risk

If there are signs that the economy is highly unfavorable, then bondholders can sell some of their high yield bonds and replace them with other lucrative bonds like US Treasury bonds. In such cases, if the majority of the high yield bondholders opt to sell, the ones not willing to sell can be left at a disadvantage. This is because the supply of bonds will be much more than the demand, thereby bringing down the prices and value of the same.

• Liquidity risk

High yield bonds are traded very often in high volumes; so, they have stronger liquidity. Liquidity is defined as the ease of converting an asset into cash. Liquidity risk is the risk that the person converting their security into cash, may get a price lower than the actual value of the asset or security. This risk depends on the credit ratings of the company and the interest rates. This makes liquidity risk for high yield bonds higher than other investment-grade bonds.

• Growing interest rates

The prices for high yield bonds fall with growing market interest rates and this creates a significant risk for bond investors. When bonds get cheaper, the circle of potential investors grows for the institution offering the bonds, as compared to the limited network of investors who would invest in the same at high prices. If you are an investor, you may want to look at the duration of the bond to gauge the potential price volatility before investing. High yield bonds with long maturities tend to pose a higher risk of interest rate.

• Market risks

This category of risks applies to investors buying bonds through diversified portfolios like mutual funds or ETFs. Since these investments are highly volatile owing to the change in the market conditions and associated with short-term risks, there is a good chance that this asset class may not work in the favor of these investors.

Benefits of investing in high yield bonds

High yield bonds manage to attract investors despite the risks because of the significant benefits they offer. Here is a look at some of them:

• Attractive income

The attractive interest rates of high yield bonds can get investors a handsome return if the conditions are favorable. Since the coupon rates offered for these bonds are higher than those bonds that receive an investment-grade rating, the sensitivity to changes in interest rates is also considerably lowered. These bonds offer much higher income than investment-grade bonds and government bonds if the conditions are favorable.

• Seniority in capital structure

Despite the similarity in risk and return characteristics between high yield bonds and equities, high yield bondholders get priority over equity holders in cases of bankruptcy or liquidation. This is irrespective of the credit quality of the bond issuer. If at all the bond issuing organization goes into bankruptcy or opts for liquidation, the high-yield bondholders are paid their dues first, before important stockholders.

• Diversification of portfolios

Investing in high yield bonds is a good way of gaining exposure to various industries for risk-oriented investors. This investment tool is more accessible than other traditional asset classes in such industries. Some of these companies offering high yield bonds may not even have gone public, making these bonds the only way to invest in some industries.

• Capital appreciation

When it comes to price appreciation, high yield bonds have a higher chance as compared to other investment-grade bonds. The credit ratings can get upgraded quite handsomely if the economy also evolves in a lucrative manner.

• Low duration

Compared to investment-grade bonds, the duration for high yield bonds are much shorter. The typical duration for these bonds is up to 10 years and in many cases can be callable during half of this term. If this happens during the recovery phase of an economy, it can fetch more returns than most fixed income classes.

A note of advice on high yield bonds

Investors jumping on the bandwagon of high yield bonds are recommended to do so after thorough research about the market and the history of the company issuing the bonds. The institution offering the bonds will typically create a prospectus, which is the primary offering documents filed with the SEC by the issuer. This prospectus should offer much-required insights into the company, its history, and where it stands now. Ensure that you understand covenant protections, payment terms, and call provisions. This prospectus of a company is made available even if you are investing through mutual funds or ETFs.

It is important to remember that if the bonds are being bought for diversification, the risks have historically outweighed the benefits of diversification. This is because this is a hybrid form of investment, holding characteristics of both equity and fixed-income assets. Therefore, the beneficial impact on diversification is not much.

Investors should also consider various other factors, such as their income, net worth, the purpose of investment, any other security holdings, and the appetite for risk. A solid understanding of both risks and potential returns involved is extremely important when investing in any kind of bonds, especially high yield bonds. The onus of understanding the documents lies entirely on the investor.

If you wish, you can seek the help of a qualified financial expert or planner to help you understand these bonds in greater detail. Remember that as an investor you have every right to inquire into every detail of high yield bonds issuing companies and to be privy to all transparent facts and figures that are made available to the public.

Armed with this much-needed knowledge, you should seek to invest wisely and securely in this debt instrument. If you are a novice investor, it is recommended to stay away from high yield bonds. Once you become more seasoned in the bonds market, you can consider adding them gradually to your portfolio.