The term high yield refers to bonds or debt securities that offer high yields in return for higher credit risk. These bonds are issued by companies or governments with a credit rating below investment grade, meaning that these issuers are considered to have a higher risk of default than those with a higher rating.
Characteristics of high-yield bonds
High-yield bonds are often referred to as junk bonds. They are generally issued by companies with a more fragile financial situation, companies in difficulty or start-ups in a growth phase, which are looking to raise funds but need to offer a higher yield to attract investors due to their higher risk profile.
Credit ratings and high yield
Rating agencies such as Moody’s, Standard & Poor’s (S&P) and Fitch assess the credit quality of bond issuers by assigning ratings based on their creditworthiness. Here’s how a high-yield bond is distinguished:
- Investment grade: Bonds rated BBB- or higher by S&P and Fitch, or Baa3 or higher by Moody’s, are considered investment grade, i.e. they present a low risk of default.
- High yield: Bonds rated BB+ or below by S&P and Fitch, or Ba1 or below by Moody’s, are considered high yield, as they present a higher credit risk.
High-yield bonds offer higher yields to compensate for this increased risk. This means that investors may receive higher interest payments, but they also take on the risk that the issuer may not be able to repay the principal or pay the interest at maturity.
Why invest in high-yield bonds?
Investors choose to invest in high-yield bonds for several reasons, including:
- High yield: The main attraction of high-yield bonds is the higher rate of return they offer compared with investment-grade bonds. In an environment of low interest rates, these bonds can provide a more attractive income.
- Diversification: For investors looking to diversify their portfolios, high-yield bonds can offer exposure to companies in fast-growing sectors or emerging markets.
- Potential gains: If the issuing company improves its financial situation and obtains a better credit rating, the value of the bond may increase, offering the investor potential capital gains.
Risks associated with high-yield bonds
- Default risk: One of the main risks is that the issuer may not be able to meet interest payments or repay principal. High-yield bonds have a higher default rate than investment-grade bonds, particularly during periods of economic slowdown or financial crisis.
- Volatility: High-yield bonds are often more volatile than investment-grade bonds, as they are more sensitive to economic conditions, interest rates and issuer credit conditions. Their value can fluctuate rapidly according to the economic outlook or company-specific news.
- Liquidity: Some high-yield securities may be less liquid than higher-quality bonds, which means it may be more difficult to buy or sell them quickly without affecting the price.
- Sensitivity to the economic cycle: High-yield bonds are often more sensitive to overall economic conditions. In times of economic slowdown, the most fragile companies may face difficulties in repaying their debts, thus increasing the risk of default.
High-yield bond market
The high-yield bond market is an important component of the world’s financial markets. It is particularly active in the United States, where companies frequently use this type of financing to raise capital. Fast-growing companies, those experiencing temporary financial difficulties, or those seeking to finance acquisitions or share buybacks often issue high-yield bonds.
In addition to corporate bonds, governments in emerging countries may also issue high-yield bonds to attract foreign capital. In these cases, investors take on a risk linked both to the country’s creditworthiness and to fluctuations in the local currency against the dollar or euro.
