High-yield bonds

Definition

High-yield bonds, also known as junk bonds, are bonds that carry a higher risk of default compared to investment-grade bonds but offer higher interest rates to compensate investors for taking on this risk. These bonds are typically issued by companies with lower credit ratings or those that are financially distressed, making them attractive to investors seeking greater returns in a low-interest-rate environment. The higher yields on these bonds come with increased volatility and credit risk, requiring careful consideration by investors.

5 Must Know Facts For Your Next Test

1. High-yield bonds are rated below BBB- by major credit rating agencies, reflecting their higher risk of default.
2. Investors in high-yield bonds often seek higher returns than those available from safer investment-grade bonds, making them popular during periods of economic growth.
3. The market for high-yield bonds is sensitive to changes in interest rates and economic conditions, often leading to increased volatility.
4. High-yield bonds can be an important part of a diversified investment portfolio, helping to enhance overall returns while also introducing additional risk.
5. Default rates on high-yield bonds tend to rise during economic downturns, making it essential for investors to assess the financial health of issuers carefully.

Review Questions

• How do high-yield bonds compare to investment-grade bonds in terms of risk and return?
  • High-yield bonds present a higher level of risk compared to investment-grade bonds due to their lower credit ratings and increased likelihood of default. However, they offer significantly higher returns as compensation for this added risk. Investors must balance their desire for higher yields with the potential for greater volatility and loss when considering these investments.
• What factors should an investor consider when evaluating the potential risks associated with high-yield bonds?
  • When evaluating high-yield bonds, an investor should consider factors such as the issuer's credit rating, financial stability, economic conditions, and overall market sentiment. Understanding how these elements can influence default risk is crucial, as economic downturns can lead to increased default rates in this segment. Additionally, analyzing the bond spread can help gauge the additional risk premium that investors demand for holding these higher-risk securities.
• Evaluate the impact of rising interest rates on the performance of high-yield bonds and the overall bond market.
  • Rising interest rates generally lead to falling prices for existing high-yield bonds since new issuances may come with higher yields. This creates a challenging environment for investors who hold lower-yielding bonds. Additionally, higher interest rates can exacerbate financial difficulties for lower-rated issuers, increasing the risk of defaults and leading to greater volatility in the high-yield segment. Consequently, investors need to be proactive in managing their portfolios and assessing the impact of macroeconomic trends on their investments.

Related terms

Credit Rating: A credit rating is an evaluation of the creditworthiness of a borrower, which can affect the interest rate charged on loans or bonds.

Bond Spread: The bond spread refers to the difference in yield between a high-yield bond and a benchmark government bond, indicating the additional risk premium required by investors.

Investment-Grade Bonds: Investment-grade bonds are bonds rated BBB- or higher by credit rating agencies, indicating lower credit risk and generally offering lower yields than high-yield bonds.