Companies and governments issue bonds to raise money, and they pay only as much interest as they have to pay to attract investors. A financially rock-solid company or government will attract investors with an interest rate that is only a little above the inflation rate. A financially troubled borrower has to offer a better deal.
- The low-yield bond is better for the investor who wants a virtually risk-free asset, or one who is hedging a mixed portfolio by keeping a portion of it in a low-risk asset.
- The high-yield bond is better for the investor who is willing to accept a degree of risk in return for a higher return. The risk is that the company or government issuing the bond will default on its debts.
In the worst-case scenario, which is bankruptcy, bondholders are first in line for repayment, but getting back all or even some of the money invested is a faint hope.
Understanding Bond Yields
Bonds make periodic payments of interest, known as coupon payments, to the bondholder. A bond's indenture–that is, its contract–details the timing and method of payment.
Key Takeaways
- The bond's rating tells you the degree of risk that the company issuing it will default on its obligations.
- The lower the rating, the higher the yield will be.
- The higher the rating, the safer your money will be.
Companies and municipalities frequently issue bonds to raise money for specific projects. It can be to their advantage to borrow the money rather than spend a chunk of the cash they have on their balance sheets.
Each bond issued is rated by one of three major rating companies, and the quality of the bond is determined by the quality of the issuer. The rating reflects the agency's opinion on the issuer's ability to make good on all of its coupon payments and return the money invested when the bond reaches its maturity.
In the investment world, any bond that is not a U.S. Treasury bond has some degree of risk, however slight.
The yield offered for the bond will reflect its rating. The higher the yield, the more likely it is that the firm issuing the bond is not of high quality. In other words, the company that issued it is at risk of default.
The Ratings and What They Mean
Three major credit rating agencies evaluate the bond issuers based on their ability to pay interest and principal as required under the terms of the bond. They are Standard & Poor's (S&P), Moody's, and Fitch Group.
- The highest S&P rating a bond can have is AAA, and the lowest is CCC. A rating of Dindicates that the bond is in default. Bonds rated BB or lower are considered low-grade junk or speculative bonds.
- Moody's ratings range from Aaa to C,with the latter indicating default. Bonds rated Ba or lower are low-grade or junk.
- Fitch ratings range from AA+ to C. Anything lower than BB- is deemed highly speculative.
High-Yield and Investment Grade
High-yield bonds tend to be junk bonds that have been awarded lower credit ratings. There is a higher risk that the issuer will default. The issuer is forced to pay a higher rate of interest in order to entice investors.
High-rated bonds are known as investment grade. They offer lower yields with greater security and a great likelihood of reliable payments.
There is a yield spread between investment-grade bonds and high-yield bonds. Generally, the lower the credit rating of the issuer, the higher the amount of interest paid. This yield spread fluctuates depending on economic conditions and interest rates.
The Old Reliable T-Bond
From the perspective of the professional investor, every bond that is not a U.S.Treasury bond (T-bond) has some degree of risk. The T-bond is the gold standard of investment-grade bonds. Its returns are notoriously low but its reliability is famously great.
On the other side of the risk spectrum, there are exchange-traded funds (ETFs) that invest only in high-yield debt. These ETFs allow investors to gain exposure to a diversified portfolio of lower-rated bonds.
This diversification across companies and sectors gives some protection against default risk. Still, a recession or a sustained period of high market volatility can lead to more companies defaulting on their debt obligations.
FAQs
The low-yield bond is better for the investor who wants a virtually risk-free asset, or one who is hedging a mixed portfolio by keeping a portion of it in a low-risk asset. The high-yield bond is better for the investor who is willing to accept a degree of risk in return for a higher return.
Are high-yield bonds better than low yield bonds? ›
High-yield bonds may allow you to realise a better return on investment than other types of bonds. However, they may be riskier owing to their high risk of default and if the economy enters recession. Hence, it is always wise to consult a financial advisor such as IIFL to ensure you make informed financial decisions.
Should you buy bonds when yields are high or low? ›
Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.
Are high-yield bonds a good investment now? ›
Additionally, the quality of high-yield bonds has improved recently, according to Northern Trust. “High yield issuers generally have become larger and more diversified, improving their ability to weather economic adversity.” In 2024, a high-yield bond could potentially be a way to diversify an investor's portfolio.
Is higher or lower YTM better? ›
The higher the yield to maturity, the less susceptible a bond is to interest rate risk. There are other risks, besides interest rate risk, that can increase yield to maturity: the risk of default or the risk of a bond getting called before maturity.
What are the risks of high yield bonds? ›
While high-yield bonds do offer the potential for more gains compared to investment-grade bonds, they also carry a number of risks, like default risk, higher volatility, interest rate risk, and liquidity risk.
What percentage of a portfolio should be in high yield bonds? ›
Meketa Investment Group recommends that most diversified long-term pools consider allocating to high yield bonds, and if they do so, between five and ten percent of total assets in favorable markets, and maintaining a toehold investment even in adverse environments to permit rapid re-allocation should valuations shift.
Do bonds lose money in a recession? ›
The short answer is bonds tend to be less volatile than stocks and often perform better during recessions than other financial assets. However, they also come with their own set of risks, including default risk and interest rate risk.
What happens to high yield bonds when interest rates rise? ›
When interest rates rise, prices of existing bonds tend to fall, even though the coupon rates remain constant, and yields go up. Conversely, when interest rates fall, prices of existing bonds tend to rise, their coupon remains constant – and yields go down.
Should you sell bonds when interest rates rise? ›
Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.
If you purchase a 10-year Treasury at time of writing, you could expect a yield of about 4.45%. Based on yields over the past 20 years, you can expect average interest payments of between 3% and 4%.
What are the cons of bonds? ›
Cons
- Historically, bonds have provided lower long-term returns than stocks.
- Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.
Despite the simplicity of coupon rate and even current yield, we believe yield to maturity is the best measure to compare like bonds. However, one important factor that investors should not overlook is reinvestment risk.
What is the advantage of high yield bonds? ›
Stock investors also often turn to high-yield corporate bonds to fill out their portfolios as well. This is because such bonds are less vulnerable to fluctuations in interest rates, so they diversify, reduce the overall risk, and increase the stability of such high-yield investment portfolios.
Is a high or low treasury yield better? ›
Treasury yields also show how investors assess the economy's prospects. The higher the yields on long-term U.S. Treasuries, the more confidence investors have in the economic outlook. But high long-term yields can also be a sign of rising inflation expectations.
Is it better to have a high-yield? ›
Rates fluctuate – Rates may move up and down, preventing you from predicting your return over time. Not the best choice for long-term savings – High-yield savings accounts offer much better interest rates than traditional savings accounts, but often, you won't earn enough over the long-term to account for inflation.
Why is a lower yield better? ›
While higher yields might reflect increased risk, they can also present opportunities for higher returns. Keep in mind, lower yields often indicate a more stable investment but might have limited upside potential.
