Bonds that offer higher yields than investment-grade bonds at a higher default or credit risk are called high-yield bonds or junk bonds. These bonds represent one of the different types of bonds categorized based on the level of risk involved.
Investing in these bonds can provide higher potential returns at higher risk. This is the reason why these bonds are also referred to as non-investment-grade bonds and speculative-grade bonds. This article discusses the pros and cons of high-yield bonds
Pros: Advantages of High-Yield Bonds
The appeal of high-yield bonds to certain investors comes from their superior investment return potential. These bonds offer higher interest or coupon rates and better overall yields than investment-grade callable bonds and short-term bonds or other traditional bonds. Nevertheless, because of their potential for higher returns, investing in these bonds is ideal for those with a higher risk tolerance and who want to maximize their investments.
Adding these bonds to an entire investment portfolio can also mean expanding passive income generation from fixed-income securities, building investments that have more dependable returns than stocks, and reducing risks through the further diversification of the specific bonds portfolio and the entire portfolio of investments.
It is also worth mentioning that high-yield bonds in the United States have historically provided equity-like returns with less volatility than stocks. Investors have been able to recognize the value of holding these bonds by maintaining a long-term allocation and taking advantage of the regular coupon payments to improve their fixed-income investment portfolio. The following are the specific advantages of high-yield bonds or junk bonds:
• High Coupon Rates and Potential Higher Yields: One of the advantages of high-yield bonds is that their issues offer higher coupon rates than traditional investment-grade bonds. Investing in these bonds also has the potential to generate higher yields or returns that can rival investments in stocks.
• Low Correlation To Investment-Grade Bonds: These bonds also have a low correlation to investment-grade bonds such as superior corporate bonds with high credit ratings and reputable government bonds like Treasuries. This means that they are less sensitive to rising interest rates than their counterpart bonds.
• Can Enhance Overall Portfolio Diversification: Purchasing and holding these bonds also have diversification benefits. Their low correlation to other bonds lessens the sensitivity of an entire portfolio to interest rate hikes while their higher risk-return tradeoff maximizes the return potential of a bond portfolio.
Cons: Disadvantages of High-Yield Bonds
The term “junk bonds” first emerged among traders during the 1920s as part of their efforts to describe and capture the characteristics of bonds issued by entities with questionable credit capabilities and untested reputations. It was in 1919 when publisher and investor John Moody used the less disparaging term “high-yield bonds” to refer to the same type of bonds. These two terms are now commutable in modern investing and trading usage.
Nevertheless, as far as their specific characteristics are concerned, these bonds are rated below investment grade based on the standard of reputable credit rating agencies. General examples include bonds with a credit rating of no more than BB based on Fitch and S&P or those rated BA or below based on Moody’s are considered junk bonds or high-yield bonds.
These bonds are normally issued by companies that are relatively new or by other entities that have experienced recent financial difficulties. Their issued bonds trade at higher yields than bonds from investment-grade issuers. Loaning funds to these issuers comes with higher default risk due to their higher potential for defaulting on their debt obligations. Below are the specific disadvantages of high-yield bonds or junk bonds:
• Potential Losses From Higher Default Risk: Bonds have risks. However, when it comes to high-yield bonds, some of these risks are higher. These bonds have higher credit or default risks because they come from issuers with untested financial standing or questionable current and future financial capabilities.
• Higher Interest Rate Risk and Liquidity Risk: High-yield bonds are also more vulnerable to fluctuations in interest rates. These bonds also expose investors to a higher level of liquidity risks stemming from the incapability to sell these bonds at an ideal time and for the price that reflects their true or intrinsic value.
• Suitable For Seasoned and Aggressive Investors: These bonds are not ideal for emerging investors or those whose investment portfolios are not diversified enough. The higher potential for incurring losses would mean that an investment portfolio composed of high-yield bonds is at higher risk of losing its value.
