High-yield bonds are corporate debt securities. While they offer higher yields than investment-grade bonds.
What Are High-Yield Bonds?
High-yield bonds are corporate bonds issued by companies with lower credit ratings than investment-grade bonds. Startup companies or capital-intensive firms issue high-yield bonds and promise to pay the interest regularly and return the principal amount on maturity of bonds.
These bonds are classified by their credit quality, and there are two types: investment grade and non-investment grade. Investment-grade bonds have higher credit rates, while Non-investment-grade bonds, or high-yield bonds, have lower credit ratings from the leading credit agencies.
High-yield bonds are broken down into two subcategories:
Fallen Angels: Fallen angels are high-yield bonds issued with investment-grade.
Rising Stars: Rising stars are high-yield bonds issued with lower credit ratings but have since been upgraded to investment-grade status due to improvements in the financial health of the issuing company, which results in price increments of such bonds.
Advantages of High-Yield Bonds
Let's have a look into the benefits that an investor could have if he invests in high-yield bonds.
1. Higher Payout Compared to Investment-Grade Bonds:
High-yield bonds offer a much stronger return than their safer, investment-grade bonds. Put differently, while a high-yield bond pays out, it is always going to yield more than a similarly sized investment-grade bond.
2. Potential for Appreciation with Improved Credit Standing:
This investment in high-yield bonds can be very rewarding if the issuing company improves in creditworthiness. During times when companies are working on enhancing their financial health and credit rating, the values of their high-yield bonds go up in price.
3. Bondholders get paid out before stockholders when a company fails:
In the unfortunate event of a company's default, bondholders have priority over stockholders when it comes to recovering their investments from the sale of the company's assets. This means bondholders are more likely to receive payments before stockholders. While defaults render both bonds and stocks worthless, investing in high-yield bonds can offer a more secure position compared to stocks.
4. Higher Payouts with More Reliable Returns Than Stocks:
High-yield bonds not only offer higher returns than traditional bonds but also provide more consistent payouts compared to stocks. While stock returns fluctuate with company performance, high-yield corporate bonds typically deliver stable returns each pay period, barring any defaults. This makes them a dependable option for investors seeking higher yields without the volatility associated with stocks.
Why to Invest in High-yield bonds?
High-yield bonds may offer several benefits to investors that can be managed by diversifying their portfolio with various other investments like bonds in different companies or investments in stocks or any other financial institution.
1. Diversification Benefits:
Adding high-yield bonds to a diverse fixed-income portfolio can reduce overall risk and potentially improve consistent returns, though it doesn't guarantee against losses.
2. Enhanced Current Income:
High-yield bonds offer higher yields compared to government and many investment-grade corporate bonds.
3. Capital Appreciation Potential:
Economic improvements or better company performance can boost the price of high-yield bonds, providing potential capital gains.
4. Equity-Like Return Potential:
High-yield bonds and stocks often respond similarly to market trends, potentially offering comparable returns over full market cycles. However, high-yield bonds usually have less volatility due to their higher income component, which adds stability. Bondholders also have priority over stockholders in bankruptcy, enhancing the chance of recovering investments.
5. Relatively Low Duration:
High-yield bonds typically have shorter maturities, often under 10 years and callable after several years. They are less sensitive to interest rate changes than to economic and corporate performance. In a rising rate environment during the economic recovery, high-yield bonds could perform better than many other fixed-income assets. However, they can also perform well in low-growth periods if issuers manage their debt effectively.
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Also read: Smart Way to Invest in High-Yield Bonds
Impact of Rising Interest Rates on High-Yield Bonds
When interest rates increase, the market value of high-yield bonds may decrease as newer bonds offer higher returns. However, rising interest rates can also benefit high-yield bonds because they often accompany economic expansion, which can boost corporate earnings and reduce the risk of default for bond issuers.
Bottom Line
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