High Yield Bonds. What are They and Should You Invest in Them?
A high yield bond is a type of bond (read more about what a bond is here).
All bonds are given a rating by Moody’s or Standard & Poor (a market intelligence company established some 150 years ago) so that investors understand the quality of the debt they’re buying. High yield bonds are also known as ‘junk bonds’ and are typically rated BB, B or CCC before actually being rated in default as C or D rated bonds.
When you’re deciding to invest in bonds, the poorer the debt the higher the risk and therefore the higher yield you receive as a way for these bonds to attract investors.
Should you invest in a high yield bond?
Each investor has a different appetite for risk and a different strategy to achieve their goal of creating wealth, but here are a few key things to know before you invest in high yield bonds:
1. All individual bonds trade at either a discount or a premium but rarely at their true or face value.
This means that if you buy when interest rates are up or rising, the bond price will be down or going down, (often trading at a discount) which can be a good time to buy. Conversely, as interest rates go down, the bond price goes up, (often trading at a premium) which can be a good time to sell for a profit.
2. If you hold your bond to maturity you will receive the face value of the bond back which is great if you bought this at a discount.
If you purchased a bond at a premium and hold this to maturity then you will only receive the face value back. This means that you will need to have made enough from the income return on the bond to make back the capital loss to break even or exceed the capital you invested to make a profit.
3. When interest rates go up, so does your risk of the company issuing the bond you’re invested in defaulting.
High yield bonds a.k.a junk bonds and or emerging market bonds (also high yield) are the riskiest types of bonds you can buy. When interest rates go up, the logic is that interest rate increases are a reflection of a strong or booming economy and therefore enabling companies the revenue they need to repay their debts. However, when interest rates increase so do the loan repayments and commitments of the company issuing the bond. If they default, this means you could lose all the funds you have invested into the bond.
Some companies issuing bonds will refinance or fix their repayments on loans/debt commitments to reduce risk in a rising rate environment. To de-risk your investment into a high yield bond it’s important to monitor the bankruptcy rates as an additional measure to understand the likelihood of the company issuing the bond defaulting and declaring bankruptcy.
4. If you’re invested in a bond fund, the bonds they invest in can go up and down in price affecting the funds return and in-turn your return. The price of the bond fund itself can also go up and down in price, affecting your return when you sell out of your investment.
A bond fund (a fund that invests predominately in bonds or debt securities) doesn’t mature at face value at the end of the term, the bonds they invest in do. So when investing in a bond fund you’re subject to price changes, like how stocks on a stock exchange go up and down in value. If the stock market pulls back or enters a bear market cycle (downturn in the market) often bond fund prices will also pull back.
5. Different types of bonds react differently in different market cycles. High yield and emerging market bonds are often the worst performing during a bear market.
There is a high correlation between the stock market and high yield bond prices. This means that when the stock market pulls back and or enters a bear market cycle, investors become risk adverse and therefore they will typically exit or sell out of position that they deem to be risky or riskier. As high yield and emerging market bonds are the highest risk in terms of bonds, they will often feel a pull back when the stock market pulls back as investors sell out. When demand is less this also causes bond prices to fall.
Bond funds invested in high yield of emerging market bonds are also likely to suffer declining values when stock markets pull back.
There are however bonds that have historically performed well during bear markets such as treasury bonds, municipality bonds, treasury inflation protected securities (TIPS) and banks — they are after all the ones profiting from interest rates increasing.
Side note: some bank backed fixed income investments come with added protection for investors. Banks have to maintain a certain amount of capital, meaning they need to have a certain amount of assets and income to offset their debts and liabilities. Often if they are in breach of these amounts, regulators will have non-viability triggers meaning your bond may be converted into company shares that can be sold on the public market, reducing your capital loss risk as an investor.
When investing, it’s important to look behind the appealing sales pitch and the immediate benefits and understand the risks. This helps you as an investor to make an informed decision and one that protects and grows your investment which is the ultimate goal.
Even though bond prices drop when interest rates rise, the benefit with high yield bonds is that their bond price is less likely to fall at the same percentage rate as safer bonds (ones with a better rating and less yield). The reason for this is that investors are attracted to the higher yield until they go bearish on risk.