High-yield bonds, also called non-investment grade bonds or junk bonds, are debt securities that corporate companies issue. Though certain risks are involved, they offer a higher yield than investment-grade bonds. They are more volatile but provide significant benefits when evaluated in depth. Corporate firms issue these bonds as a means to raise capital for expansion, growth, debt restructuring, or other business needs. Keep reading to learn more about the concept of high-yield bonds in detail.

High-yield bond

High-yield bonds are usually issued by start-ups or capital-intensive firms with huge debt ratios. These are high-risk investments but pay higher interest rates. Compared to investment-grade bonds, high-yield bonds possess lower credit ratings. The latter offers investors a higher yield than the former, and these are more likely to default. High-yield bonds are just like other corporate bonds. However, risks exist only because the issuers of these bonds have low credit ratings.

Categories

Primarily, the high-yield bond is divided into two subcategories, which are mentioned below-

1. Fallen angels- It is a bond downgraded by a credit rating agency. It is demoted when the issuer falls into lower credit quality levels. Investing in fallen angels is riskier as they move towards junk bond status.
2. Rising stars- The rising star is a bond whose credit value increases due to the issuer’s improving credit quality. The credit rating agencies raise the credit ratings of the bonds. Though the rising stars may still be categorized as junk bonds, these often move toward being of investment quality.

Types

The types of high-yield bonds are detailed below.

1. Zero-Coupon Bonds- The Zero-Coupon Bonds are redeemable at par and issue a deep discount. No interest is offered to the investor or the bondholder.
2. Step-Up Bonds- With the step-up bonds, the initial coupons are lower and may increase later.
3. Deferred Interest- In the deferred interest bond type, there is no interest payment until the bond’s life period, and thus, higher coupons are offered later to make up for the shortfall.
4. Pay in kinds of Bonds- Here, the coupons are replaced with the additional debts. These extra debts carry a higher coupon rate but are riskier investments.
5. Extendable Reset Notes- With the extendable reset notes, the maturity of the outstanding debt is extended with the new coupon. It is done at periodic intervals. An additional feature is also provided, where the investor can sell back the bond to the issuer.
6. Equity-Linked Bonds- These bonds work as convertible bonds, and the holder can convert or change the bondholding to equity holding.

Benefits

Besides the higher interest rates, there are other advantages to high-yield bonds, some of which are mentioned below.

1. Security- Several investors feel these bonds are unsafe, and the amount is lost during the default. But this is not the entire scenario. High-yield bonds are much safer than the stocks issued by the same organization.
2. Improved spread- A significant spread is offered over treasury securities. They may offer excellent returns within a short period compared to other investments.
3. Diversification- These bonds have a low correlation with other types of fixed-income investments, hence, offering consistency in returns. It also lowers the portfolio risk.
4. Low duration- The overall duration is reduced because of the shorter maturity. These are generally callable within three to five years.

Drawbacks

The disadvantages of the high-yield bond are stated below:

1. Default risk- There is default risk involved as the fallen angels or rising stars fluctuate in credit quality.
2. Higher volatility- The high-yield bonds are highly volatile compared to investment-grade bonds. Any economic downturn can affect the face value and coupon rate of junk bonds.
3. Liquidity risk- These bonds have higher liquidity risks than investment-grade bonds.
4. Interest rate risks- Sometimes, high-yield bonds are not considered the best options, as interest rate risks are involved. It occurs when the bond’s market value change with fluctuating interest rates.

High-yield bonds provide both rewards and risks. The price factor depends upon the bonds’ credit rating, interest rates, capital appreciation, and yield. If the investor has a high-risk tolerance, they may invest in high-yield bonds. However, factors like income, investment goals, risk tolerance, and net worth must be considered when choosing these bonds. Furthermore, consulting a financial expert is the best choice before making any decision, and make sure to weigh all the benefits and drawbacks of high-yield bonds. Such bonds will benefit investors who are ready to accept a certain degree of risk in exchange for a higher return.