High yield bonds are debt securities issued by companies that are considered to be below investment grade (e.g., BBB- or below). They have a greater risk of default than government bonds, but also offer a higher yield on the investment due to their increased risk.
Most investors, who prefer not to take on the additional risk associated with high yield bonds, purchase them through mutual funds and exchange-traded funds that invest in such debt securities.
They can also purchase high yield bonds directly from the company that issues them, typically in fixed-income investment vehicles such as an individual retirement account.
Types of High Yield Bonds
There are two major types of high yield bonds: convertible debt and debentures. Both have risk attached to them, but they differ in some ways as well.
For example, with a convertible bond, if interest rates rise you could see your principal drop sharply; but since a debenture is just a loan, it can't be converted into shares like a bond can.
One thing that's similar about both types of bonds is that you'll pay dearly for taking on higher risk - about double what regular Treasuries would cost for instance.
In other words, if you're willing to buy one of these bonds, it's because you think there's some big upside potential from buying now before interest rates really go up.
Types of Issuers
The type of bond issuer can be important in determining how high of a yield an investor will receive. Governments, which include state and local governments, municipalities and sovereign entities, frequently issue bonds.
These securities tend to be ultra-safe because they’re backed by either taxes or other debt issuances.
Companies that have a track record of making regular interest payments on their bonds may also look attractive to investors who want higher yields.
Junk bonds can offer yields well into double digits, but carry greater risk for potential default. There is also a third group of high-yield instruments that fall somewhere between government and corporate debt: U.S.
The History of Junk Bonds
Before there were high yield bonds, investors could only invest in blue-chip companies and government securities. As a result, returns were low—but so was risk. If a company went belly up, bondholders would receive their original investment plus interest.
Then junk bonds entered on to the scene with their higher interest payments. Junk bonds have earned their nickname from investors who think they’re risky because they don’t have steady earnings or predictable dividends.
But junk bond holders also know that should a company go bankrupt, they will get back 100% of their original investment before any other creditors do... and then everyone else can fight over what’s left.
How Do High Yield Bonds Work?
If you’re thinking about investing in bonds, it’s important to know how they work. Understanding how interest rates affect their performance is particularly critical.
Because there are a number of different types of bond, it is also helpful to understand how each type is affected by interest rates and inflation.
Here’s what you need to know about high yield bonds What Are High-Yield Bonds? Unlike most other bonds, which carry fixed interest rates over an extended period of time, high-yield bonds (also known as junk bonds) offer variable returns based on current market conditions.
The higher risk associated with these investments means that investors typically receive higher yields than with more traditional forms of debt. There are two primary ways that high-yield bond issuers can pay investors:
They can either pay regular dividends or make one large payment at maturity. While both options provide some level of income for investors, dividend payments tend to be smaller but come more frequently than one large payment at maturity.
How Do Interest Rates Affect Their Performance?: When market interest rates rise (fall), so do those for junk bonds.
Calculating the Cost of Capital
If you want to know whether or not a business project is likely to generate enough cash to justify its cost, you must first determine what that cost is.
The so-called cost of capital represents your investment’s opportunity cost—that is, what could have been earned by investing your money elsewhere.
In order to calculate it, you must know how much money would be required today if you wanted to acquire that capital in an arm’s length transaction from another person who would use it as an investment asset.
This amount becomes your hurdle rate; any project with a pretax net return in excess of that rate should be considered for funding.
Key Factors in Issuing a Bond
There are a few factors that play into what type of bond will be issued by a company. These include: who is purchasing the bond, how often they will buy them and at what price, when they need to be paid back and their intended purpose.
For example, a higher-yield bond may not be appropriate for a retirement fund but would be perfect for an investor looking to earn more on their investment over time.
Who Buys High-Yield Debt?
Businesses that issue high-yield debt typically rely on it to meet short-term cash flow needs, or to support acquisitions or capital expenditures.
Because of their relatively high risk and lack of government backing, high-yield bonds tend to pay higher interest rates than investment grade bonds.
This is why they’re often referred to as junk bonds. Other investors include hedge funds and large money managers.
They might buy a number of different types of securities depending on their strategy, but many have significant holdings in junk bonds because they generally perform well during periods of economic expansion when interest rates are rising.
What Are the Benefits of high yield bonds?
The interest rate for high-yield bonds is called a coupon. The coupon must be reinvested every year to maintain ownership of a bond, so as yields rise on other investments (such as 10-year Treasury notes), high-yield bonds become more valuable.
In fact, they've had a stellar run since 2000, according to Bank of America Merrill Lynch data. Meanwhile, default rates have been falling: From 1970 through 2005, average cumulative defaults in high-yield were 4.7%, but that dropped to just 1% between 2010 and 2016.
Things to Consider Before Purchasing a High-Yield Bond
Before purchasing a high-yield bond, take some time to research your investment. The risks of purchasing a high-yield bond can be much higher than other investments, so make sure you’re comfortable with that and can handle those risks.
You may want to purchase bonds in an account at your broker where you can sell them easily if you decide that they aren’t right for you.
And if you do decide to purchase one, try not to put all of your eggs in one basket.
You may want to invest in several different bonds from different issuers so that if one goes belly up it won’t have a significant impact on your portfolio overall.