High Yield Bonds
High Yield Bonds, often referred to as "junk bonds," are bonds that carry a high risk of default and, as a result, offer a higher yield than investment grade bonds. A high yield bond is classified as having a credit rating of BB+ or lower, while bonds with rating of BBB or higher are known as investment grade. Debt instruments are the converse of equity instruments, or stocks, and generally perform better than equities during economic downturns. This generality holds because debt holders have the first claim on a company's assets. In recessionary periods when cash flows are tight, the companies are required to pay their bond holders before their shareholders receive anything.
Junk bonds are the ones that usually pay a high yield because their credit ratings aren’t stellar. Therefore, in order to borrow money from outside investors, they must pay a higher interest rate in order to attract people to lend them money. This higher interest rate reflects the higher chance of default by the company.
High yield bonds can be bought individually through a broker or in bulk through mutual funds. A high yield mutual fund is a better choice for individual investors because it reduces risk. This is because the risk is spread over a larger number of contracts, which is known as diversifying your credit risk of high yield bonds. That is, while any single bond within the fund may have a relatively high probability of default, when many are grouped together the risk that all, or even most, of the bonds defaulting is much lower. In fact, historically the average rate of default between 1971 and 2008 was 3.18%, and even when a high yield bond defaults, bond holders are able to recover on average 44 cents on the dollar. Therefore, even when high yield bonds default, the investor often does not lose the entire principal.
There are other considerations to take into account besides simply the yield and credit risk. There are two ways high yield bonds enter the market. The first are high yield bonds that are issued by corporations whose credit rating is below investment grade at the time of issue. Because the debt that is being issued is backed by corporations that may a higher chance of being unable to repay, their debt is considered below investment grade and therefore they must pay a higher interest rate. The second way are bonds issued by corporations that were investment grade at the time of issue, but whose credit rating fell below investment grade. For example, suppose Company X currently has a credit rating of AA (investment grade), and issues bonds that expire in 10 years. Two years later, Company X's performance has fallen off considerably, and its credit rating is now BB+, meaning it is now below investment grade. Therefore, even though the bonds were initially investment grade bonds, it can still fall below investment grade and turn into a high yield bond. These are often referred to as "fallen stars".
When investment grade companies' credit ratings drop to below investment grade, the bond now not only has a higher risk of default, but the price of the bond will fall as well. Therefore, if you plan to sell the bond before maturity, your holding period return will suffer with drops in credit ratings. Conversely, if you purchase a high yield bond, and the company's credit rating improves to investment grade, the value of your bond will increase significantly. An investor can view the interest payments as analogous to dividend payments made by stocks while changes in credit ratings are somewhat analogous to changes in the bond price.
From a purely technical standpoint, high yield bonds aren’t any different from regular bonds, since they act as the professional equivalent of an IOU. Every high yield bond has an agreed upon principal (the amount the company will pay back), maturity date (the date it will pay back the amount), and coupon or interest it will pay on the borrowed amount.
The reason that high yield bonds are classified differently from normal, run-of-the-mill bond is due to the credit quality of the issuers. Since all bonds are “graded” on the same scale - and there are only two grades they can fall under - junk bonds are anything that don’t meet the Investment Grade restrictions: i.e. issued by low or medium-risk lenders..