Learn the basics of how high-yield bonds work, the pros and cons, and how to invest in them.
What Are High-Yield Bonds?
A high-yield bond is a corporate bond issued by a company that’s at a higher risk of defaulting on its debt. Corporations or governments often finance debt by issuing bonds. Basically, when you buy a bond, you become a creditor. Companies may issue high-yield bonds if they’ve had financial troubles or if they’re heavily in debt. A new company may be unable to obtain an investment-grade rating because it doesn’t have a proven track record or its business plan is seen as risky. If a company’s financial performance or creditworthiness improves, ratings agencies can upgrade its bonds to investment-grade status. Likewise, investment-grade bonds can be downgraded if the issuing company’s financial health declines.
How Do High-Yield Bonds Work?
In general, a company works with an investment bank to draft a high-yield bond offering. Once the terms are set, the bonds are offered to investors. Any bonds that are sold before maturity make their way into the secondary market for brokers and dealers to offer to investors. Most corporate bonds offer fixed interest payments called “coupons,” which are often paid semiannually. When a bond reaches its maturity date, the investor should receive the full principal amount they invested (provided the company has the financial means to do so). A high-yield bond is seen as less likely to make on-time payments than its investment-grade counterparts, so it offers higher interest. If the company defaults on its debt and goes into bankruptcy, bondholders are paid only after secured creditors are paid, such as a bank that holds a mortgage. However, bondholders must be paid in full before shareholders recoup any funds.
What Are the Risks of High-Yield Bonds?
Investors seek high-yield bonds for the possibility of higher returns, especially in times when interest rates are low. But there are several types of risks to be aware of.
Default Risk
Default risk, also known as “credit risk,” is a concern. Companies that issue high-yield bonds do so because their credit ratings indicate that they’re more likely to fail to default on debt. Investors could lose their entire principal should this occur.
Interest-Rate Risk
Because interest rates are more likely to change over time, interest-rate risk is greater for bonds with longer maturities. A bond’s value drops as the market’s interest rates rise, and vice versa. So if the market rates rise near the end of your bond’s maturity, its value could go down.
Economic Risk
In economic downturns, investors often sell riskier assets and seek a safe haven in low-risk investments, like Treasurys. If too many bond traders sell at once, it could push your bond’s price downward.
Liquidity Risk
Liquidity risk is the chance that you won’t be able to sell the asset quickly for its value. An asset that trades frequently has higher liquidity than one that trades infrequently. High-yield bonds typically have higher liquidity risk than investment-grade bonds.
How Do I Invest in High-Yield Bonds?
If you feel the potential returns are worth the risk, you can buy high-yield bonds in several ways.
Individual High-Yield Bonds
You can invest in individual high-yield bonds by buying them directly from banks, brokers, or dealers. But because the risk of default is high for companies with low credit ratings, buying individual bonds is a risky way to invest, as your money is tied up in a single company. Before investing in individual high-yield bonds, be sure to read the company’s prospectus on the SEC’s EDGAR website to better understand the company’s financial picture.
High-Yield Bond Funds
Investing in a high-yield bond fund, whether it’s a mutual fund or a high-yield exchange-traded fund (ETF), could be a good way to spread out default risk when you invest in junk bonds. For example, the SPDR Bloomberg Barclays High-Yield Bond ETF (JNK) invests in high-yield bonds with above-average liquidity and maturities between one and 15 years. Its 30-day SEC yield as of October 2022 was 8.98%. The fund’s expense ratio is 0.40%, which means that $40 of every $10,000 you invest goes toward fees.
