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What Are High-Yield (Junk) Bonds? Are They Safe?

Often, the default risk of investing in high-yield bonds outweigh their juicy yields.
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High-yield bonds are behind some of Wall Street’s greatest scandals.

What Is a High-Yield Bond?

High-yield bonds are corporate bonds that offer high rates of interest in exchange for your investment dollars, but along with the potential for juicy returns come quite a few risks. High-yield bonds are issued by companies that are judged likely to default, which means they might fail to make interest and principal payments on schedule, making the bonds worthless. For this reason, they are also known as junk bonds.

What Are the Features of High-Yield Bonds?

High-yield bonds typically . . .

  • Have short-term maturities of between 4 and 10 years.
  • Have lower credit ratings than investment-grade bonds, (which we will discuss more below).
  • Offer a higher yield to compensate for the increased risk of default.

High-yield bonds offer yields that are high relative to those of better-quality bonds of comparable maturity. The yield of a junk bond may be higher because it has a bigger coupon, or because it trades at a lower price.

Interestingly, a high-yield bond wasn’t always born that way. A bonds that trades at a price significantly below its par value (face value) may not always have been a high-yield bond. It may have started out as an investment-grade bond, trading closer to par, and become a high-yield bond as its price dropped, reflecting deterioration in the issuer's ability to service its debt.

Who Issues High-Yield Bonds?

As of the end of 2021, more than 15% of the corporate bond market was made up of high-yield bonds. At the time, this chunk of the market was estimated to have around $1.7 trillion in value.

So, who typically issues them? High-yield bonds could be issued by companies who have received a credit downgrade but who need to raise cash fast. These are known as fallen angels. Or they could come from emerging companies, like startups, hoping to secure more capital investment. These are known as rising stars.

How Safe Are High-Yield Bonds?

The saying goes, “the greater the risk, the greater the reward,” but when it comes to high-yield bonds, greater yields and potentially higher long-run returns may be outweighed by their risks. Here are some of them:

  • The biggest risk that comes with high-yield bonds is default risk, the chance that the bond issuer will fail to make interest payments, return the principal, or both.
  • All bonds are susceptible to interest-rate risk, as rising interest rates cause the value of bonds to decline, and vice versa.
  • High-yield bonds experience higher volatility than investment-grade bonds or Treasury securities; in fact, their price fluctuations are more in-line with stocks.
  • This category of bonds also faces liquidity risk, which is the risk that finding buyers for an asset could be very difficult.

How Are High-Yield Bonds Rated? Who Rates Them?

To help investors understand the credit quality of bonds, private rating agencies, such as Standard & Poor’s, Moody’s and Fitch Ratings, evaluate bond issuers at the time they issue a bond. They examine the issuer's ability to make all payments in full and on time, and then they publish their bond ratings in an easy-to-understand grading system, which includes a grade and risk level for each bond.

Bond RatingInvestment GradeSpeculative?

AAA

Extremely strong

No

AA

Very strong

No

A

Strong

 No

BBB

Adequate

No

BB

Faces major uncertainties, although less vulnerable in the near-term

Yes

B

Faces major uncertainties has more near-term vulnerability to adverse business

Yes

CCC

Vulnerable

Yes

CC

Highly vulnerable to non-payment

Yes

C

Default has not yet occurred, although it is expected

Yes

D

Payment default, or in bankruptcy

Yes

A bond is considered high-yield if it carries a speculative-grade rating, which includes grades BB and lower. But a bond isn’t stuck with one grade forever. If the issuer's creditworthiness improves, bond ratings agencies upgrade the bonds, and investors can see appreciation as bond value increases.

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TheStreet Dictionary Terms

How Do You Invest in High-Yield Bonds?

Because of the risk of default, high-yield bonds are usually the domain of large institutional investors. However, individual investors can partake of the sector through exchange-traded funds (ETFs) or mutual funds.

Plus, there are indices that track the high-yield bond market, such as:

  • S&P U.S. Issued High-Yield Bond Index, and
  • FTSE High-Yield Bond Index

And whenever there’s an index, there is also an exchange-traded fund that tracks it. A few examples of high-yield bond ETFs include the following:

  • iShares iBoxx $ High Yield Corporate Bond ETF (HYG)
  • iShares Broad USD High Yield Corporate Bond ETF (BATS)
  • iShares High Yield Bond Factor ETF (HYDB)

High-yield bond mutual funds include the following:

  • RBC BlueBay High Yield Bond Fund (RHYAX)
  • Fidelity Capital & Income Fund (FAGIX)
  • SEI High Yield Bond Fund (SGYAX)

Any investor who chooses to purchase high-yield bonds should do their due diligence. Every bond issuer must file a prospectus with the Securities and Exchange Commission (SEC), and every prospectus includes the following information:

  • The financial condition of the bond issuer
  • How the company plans to use the proceeds from the sale of the bonds
  • The terms of the bond
  • The significant risks of investing in the bond

Prospectuses for registered corporate bond offerings are free to the public on the SEC’s EDGAR website.

What Are Some Examples of Famous Junk Bonds?

Inflation was to blame for the rise in junk-bond yields to stratospheric levels in the 1980s. In an effort to combat stagflation, a toxic combination of stagnant growth, rising unemployment, and inflation, the Federal Reserve raised the discount rate to 12%. Bond prices fell, but yields on junk bonds soared as high as 14%, and so they became the speculative vehicle of choice for financiers behind savings & loans corporations (S&Ls), which were facing inflation-related issues of their own, like insolvencies.

Investor Charles Keating purchased as much as $51 million worth of junk bonds for his S&L, even though it technically carried a net loss of $100 million. Those junk bonds came from Michael Milken’s corporation, Drexel Burnham; both men were convicted of securities fraud and racketeering and served time in prison.

Are High-Yield Bonds a Good Investment in 2022?

When TheStreet’s ETF Focus published a list of top bond funds for 2022, a high-yield bond fund came in at number one.

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