High-yield debt, also referred to as high-yield bonds, is a potentially risky form of investing. This type of bond is traditionally issued by corporations and has the potential to provide a higher yield than investment-grade bonds.
High-yield debts are fixed-income securities that usually come with higher interest rates to make up for the fact that there is a higher risk of default. When companies issue high-yield bonds, it may be because they are unable to get an investment-grade bond credit rating. To offset this, companies will issue higher interest rates with their high-yield bonds in an attempt to appeal to potential investors. The most common types of companies that issue high-yield bonds are those that are highly leveraged, going through financial struggles, or new/small companies.
High-Yield Bonds vs. Investment-Grade Bonds
According to the U.S. Secretaries and Exchange Commission, investment-grade corporate bonds are a type of bond that traditionally have a lower default risk and higher ratings by accredited credit rating agencies. These types of bonds also usually have lower yields than bonds with lower credit ratings, like high-yield bonds. The leading credit rating agencies are Moody’s and S&P and Fitch.
How Does the Bond Market Work?
To understand the corporate bond market, think of bonds as a kind of loan. High-yield bond investors are essentially lending money to companies that issue bonds. As compensation, these high-yield issuers have a legal obligation to make interest payments on the principal amount, and in most cases, pay back the principal when the bond funds mature.
Bonds vs. Stocks
To truly understand high-yield bonds, it’s important to know how they are different from stocks/the stock market. When consumers purchase stocks, they become partial owners of the company and share in company dividends, profits, etc. The more profits a company makes, the more its stockholders will benefit. When consumers purchase bonds, they do not become partial owners of the company and therefore do not share in dividends or profits. Instead, bondholders are entitled to interest rate payments and the principal amount of their high-yield bonds. If a company makes substantial profits, they aren’t required to share any of it with bondholders.
However, if a company goes through financial hardship or even bankruptcy, they are still required to pay interest and the principal to its bondholders. Stockholders, on the other hand, may not be entitled to anything in this circumstance.
Potential Risks of High-Yield Bonds
While the high-yield market can be a bit of a financial risk, it is often appealing to investors who are able to handle that risk. However, before committing to a high-yield bond, it is important to understand the potential disadvantages.
Default Risk / Credit Risk
Since high-yield bonds tend to be issued by new and emerging companies, there is a chance they will fall into financial hardship and become unable to make interest payments or pay back the principal. Unfortunately, newer companies may be less equipped to handle financial challenges, which puts them at risk of default.
Interest Rate Risk
All bonds come with an interest rate risk. If the market value of a bond moves in one direction, the interest rates will move to the other, similar to how a seesaw works. For example, if the bond value goes down significantly, you may see the interest rates rise. Furthermore, the maturity time of a bond also plays a role in potential interest rate changes. The longer a bond takes to mature, the more likely it is that the interest rates will change. This is why high-yield bonds with longer maturities are a greater risk.
Just as the market can affect the interest rates of a bond, it can also affect other aspects as well. For example, if the economy takes a dip, some investors may want to sell their high-yield bonds. This trend is referred to as a “flight to quality.” A “flight to quality” make also cause a bond’s value to deplete further because the supply will start to exceed the demand.
Liquidity measures how easily an investor or consumer can sell an asset, or asset class, whenever they please. When bonds are traded more often at high volumes, they are said to have stronger liquidity than bonds that aren’t able to be sold as often. Since high-yield bonds tend to come with such high rates and risk of default, they can also be a major liquidity risk as well.
What to Research Before Committing To High-Yield Bonds
Before you officially commit to high-yield bonds, you may want to do some independent research on your different options. When researching high-yield bonds, be sure to pay attention to the following:
- Covenant protections.
- Payment terms.
- Call provisions.
A covenant is simply another term for an agreement. When it comes to high-yield bonds, covenants are designed to protect the bondholders by limiting what companies can do to avoid making interest payments and paying back the principal. When high-yield bonds are high in demand, issuers may have fewer covenant protections. All investors should be wary of high-yield bonds with “covenant-lite” protections. If you have any questions about the covenant protections of a bond you are thinking about purchasing, be sure to ask your broker or another financial professional for clarification.
With some high-yield bonds, the issuer is allowed to skip an interest payment if specific circumstances arise. Some payment terms for high-yield bonds also come with stipulations that allow issuers to submit a payment-in-kind, also referred to as a PIK. A PIK is a payment in the form of additional bonds instead of cash. So, make sure you are not relying on the cash you put forth towards your high-yield bond because there is a chance you won’t get it back in its original form.
Call provisions allow companies to “call” the debt or pay back a bond in full before its maturity date. Some high-yield bonds come with call protection, which prevents companies from calling a debt before a certain date. If a company calls a bond before the maturity date, the investor will receive their principal back but may not be able to reinvest at a similar interest rate.
The Bottom Line: High-Yield Bonds
When they work out the way they’re planned, high-yield bonds can be profitable for investors. However, due to high-interest rates and their potential to default, they can also be a huge financial risk. Before committing to a high-yield bond, make sure to research your options and review your financial situation.