A guide to high-yield bonds
- High-yield bonds offer investors potentially higher returns but may come with significantly more risk.
- High-yield bonds are sometimes called “junk bonds.”
- You can use rating agencies – like Moody’s, Fitch Ratings and S&P Global Ratings – to evaluate the risk associated with a high-yield bond.
High-yield bonds typically come with a higher yield attached. The catch is that high-yield bonds tend to receive low ratings from credit agencies, which indicates a higher level of perceived risk for investors.
Before adding high-yield bonds to your portfolio, it’s important to understand what they are, how they work and when these might be suitable for your investment portfolio.
What are high-yield bonds?
As the name suggests, a high-yield bond may offer a higher interest rate than other bonds on the market.
High-yield bonds may be issued by companies that are highly leveraged or experiencing financial difficulties. In some cases, smaller or emerging companies may also issue high-yield bonds because they have an unproven operating history or because their financial plan may be seen as high-risk.
Although these bonds come with higher yields, they tend to receive low ratings from credit rating agencies to indicate a higher risk of default.
The relatively risky nature of high-yield bonds leads to them sometimes being called junk bonds or non-investment-grade bonds.
What do high-yield bond ratings mean?
Several credit rating agencies rate bonds. A high rating indicates an investment-grade bond and a low rating indicates a high-yield or junk bond. Explore the metrics for a high-yield bond across different rating agencies below:
- Moody’s: A Moody’s rating of Ba or lower indicates a high-yield bond, which is considered below investment grade.
- S&P Global Ratings: An S&P Global Ratings score of BB or lower indicates a high-yield bond, which is considered below investment grade.
- Fitch Ratings: A Fitch Ratings score of BB or lower indicates a high-yield bond, which is considered below investment grade.
As you explore bonds, looking at the ratings can help you determine what level of risk comes with the potential yield.
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Pros and cons of high-yield bonds
Every financial product has advantages and disadvantages. High-yield bonds are no exception. Although investors might find the potential for high returns, these non-investment-grade bonds may come with a higher risk of losing your investment.
Explore both sides of this type of investment below:
Advantages of high-yield bonds
Some of the advantages of high-yield bonds include the following:
- Higher returns: The ability to tap into potentially higher yields is an obvious perk.
- Diversification: Adding a high-yield bond to your investment portfolio may boost your diversification across asset classes.
Disadvantages of high-yield bonds
Some of the disadvantages of high-yield bonds include the following:
- Default risks: The higher potential returns of this investment vehicle correlates with a higher level of risk. With a relatively high potential for default, investors risk losing their funds altogether with this type of investment.
- Interest rate risks: As with all bonds, high-yield bonds face interest rate risk, which means market interest rates could rise and outpace the returns of the bond.
How to invest in high-yield bonds
If you want to invest in high-yield bonds, you have two options to pursue:
- Broker-dealers: You can buy the assets directly from brokers-dealers.
- Buy shares in a high-yield bond focused fund: You can buy into a mutual fund or exchange-traded fund (ETF) that holds high-yield bonds.
Before buying through either avenue, read through the fine print relating to the specific high-yield bond, mutual fund or ETF. Seek out relevant information through offering documents, like the prospectus.
Are high-yield bonds a good investment?
For investors willing to accept a higher level of risk, a high-yield bond may be an investment opportunity worth considering. For investors unwilling to take on a higher level of risk, high-yield bonds may not suit their portfolio.
The bottom line
Ultimately, your investment goals and strategy will determine if a high-yield bond is a good fit. If you aren’t sure that high-yield bonds suit your needs, consider working with a trusted investment professional to help you navigate these decisions.
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