Typical bonds are some of the safest ways to invest your money, but their returns leave a lot to be desired. If you’re willing to accept a bit more risk in exchange for better payouts consider adding some high yield bonds to your portfolio.
High yield bonds are the more lucrative cousins of traditional investment grade bonds, but their higher returns come with more risk. That means they may not always supply a high yield, even if they have in the past (as past performance does not guarantee future results) and they could default entirely.
What are High Yield Bonds?
A high yield bond—sometimes called a junk bond—is a type of bond with a higher risk of default than government bonds or investment grade corporate bonds. To compensate for the risk, high yield bonds have great bond yield, meaning they pay more.
Credit rating agencies give ratings to bond issuers based on their ability to pay interest and principal on the bond’s payment schedule. Investment grade bonds are rated AAA (highest quality), AA (high quality), A (upper medium quality), or BBB (medium grade).
High yield bonds, however, are rated lower than investment grade bonds because they have a greater risk of defaulting. (Credit rating agencies rate them as BB, B, CCC, or CC.) High yield bond issuers have to pay higher-than-normal interest to attract investors to buy their bonds. This makes them a midpoint between typical bonds and stocks.
The high yield bond market tends to balloon whenever there’s good economic growth. This is when investors grow comfortable taking chances on riskier bonds for the promise of better returns. Naturally, the high yield bond market shrinks when the economy performs poorly and investors grow cautious.
Furthermore, the high-yield bond market can grow if a number of companies are downgraded to hide yield status. It can shrink if a number of companies are upgraded into the investment-grade market.
At one point, high yield bonds were simply outstanding bonds from companies who had been downgraded to below investment grade. Today, companies use high yield bonds to finance lots of things, like general corporate expenses, consolidating lines of credit, acquisitions, etc.
It’s worth pointing out that while agency credit ratings are great tools to help you evaluate the risk of a security, it’s always a good idea to perform your own independent research or get help from a financial adviser.
List of High Yield Bonds
It’s possible to buy individual high yield bonds, but that requires careful research, study, and knowledge. It often requires the help of a financial planner.
Most investors choose to purchase high yield bonds through exchange traded funds. High yield bond funds are groups of high yield bonds that you purchase all at once, insulating you from risk if one defaults. Basically, it’s like owning slices of different pies rather than one whole pie.
Here’s a list of the best performing high yield bond funds as of July 2019.
High Yield Bond Fund Name | Returns (1 year) | Total Assets |
|---|---|---|
| Fidelity® High Yield Factor ETF | 9.52% | $59.92M |
| WisdomTree Fundamental US Hi Yld Corp Bd | 8.97% | $20.58M |
| iShares iBoxx $ HY exOil&Gas Corp Bd ETF | 8.94% | $10.29M |
| Franklin Liberty High Yield Corp ETF | 8.73% | $10.28M |
| JPMorgan Disciplined High Yield ETF | 8.53% | $163.77M |
| IQ S&P High Yield Low Volatility Bd ETF | 8.28% | $61.37M |
| Invesco BulletShares 2024 HY Corp Bd ETF | 8.28% | $90.74M |
| iShares Edge High Yield Defensive Bd ETF | 7.88% | $27.48M |
| Xtrackers Low Beta High Yield Bond ETF | 7.78% | $143.34M |
| Goldman Sachs Access Hi Yld Corp Bd ETF | 7.55% | $81.48M |
| Invesco BulletShares 2025 HY Corp Bd ETF | 7.49% | $75.58M |
| Xtrackers USD High Yield Corp Bd ETF | 7.33% | $3.01B |
| SPDR® Blmbg Barclays High Yield Bd ETF | 7.25% | $9.69B |
| VanEck Vectors Fallen Angel HiYld Bd ETF | 7.22% | $1.14B |
| iShares Broad USD High Yield Corp Bd ETF | 7.21% | $1.43B |
| Invesco Fundamental Hi Yld® Corp Bd ETF | 7.16% | $737.35M |
| iShares iBoxx $ High Yield Corp Bd ETF | 7.12% | $19.24B |
| iShares Fallen Angels USD Bond ETF | 7.07% | $105.04M |
Pros and Cons of High Yield Bonds
Like all securities, high yield bonds come with their own benefits and drawbacks.
Pros of High Yield Bonds
Here’s how high yield bonds can add value to your portfolio.
1. Higher Payouts
High yield bonds offer higher payouts than investment grade bonds of the same size. Companies with poor credit ratings must offer a higher return, otherwise investors would stick with safer securities. High yield bonds can be quite profitable if you’re willing to carry the risk, especially if the company improves their performance while you own the bond.
2. Safer Than Stocks
High yield bonds are still bonds, meaning they’re more dependable than stocks. Payouts from stocks can vary based on the company’s performance. You could make a lot of money one year and get nothing the next. Bonds, however (including high yield bonds) pay consistently each pay period unless the company defaults. This makes them a nice addition to a fixed-income portfolio.
3. Not All Bad
While it’s true that high yield bonds are riskier than investment grade bonds, the companies who issue them are often solid, reputable companies who have simply fallen on hard times. They may have had a bad season or suddenly had to bear new costs.
These factors can affect the company’s debt obligations and hurt their rating, but that doesn’t necessarily mean it’s a bad company who won’t pay its bond. You (or your financial adviser) will need to conduct careful research to determine if the company is dealing with challenges or if they’re likely to default.
4. Low Duration
Unlike most bonds, high yield bonds typically come with shorter maturity periods. They’re usually issued with 10 year terms or less, and they’re often callable after five years. This means you don’t have to wait 30 years to maximize your investment.
Cons of High Yield Bonds
Better returns may sound great, but high yield bonds also come with some drawbacks.
1. Higher Default Rates
High yield bonds are more volatile and riskier than traditional investment-grade bonds. Companies who issue high yield bonds are more likely to default, especially in times of economic stress. When a company defaults, their bonds become worthless.
That said, companies payout their bonds before stocks when they liquidate. If a bond defaults, you’re more likely to get your cash back than a stockholder.
2. Harder to Sell
Whereas investment-grade bones are highly liquid (easy to sell on the market), you won’t always have a buyer for your high yield bonds. Many investors are hesitant to purchase these kinds of bonds on account of their risk. If you want the freedom to sell your bonds anytime, high yield bonds probably aren’t for you.
3. Market Sensitivity
High yield bonds are more sensitive to changes in the market than other securities. Investors who own high yield bonds are more likely to sell if they learn something that makes them nervous. No one wants to get caught holding a high yield bond when the company goes bankrupt, especially during a recession. This means that prices fluctuate often.
4. Credit Rating Dependency
Like all bonds, the value of high yield bonds can decrease if the issuer’s credit rating continues to fall. If the price falls too far, the return you get from the bond will fall as well. This is why it’s so important that you make sure any high yield bonds you buy are issued by stable companies.
5. They Don’t Help Diversification
Diversification is a key way to reduce the inherent risks of investing, which is why most portfolios should have a balance of stocks and bonds. But since high yield bonds comes with greater risk than investment grade bonds, they don’t really balance out your stocks. If you’re looking to diversify a stock-heavy portfolio for the sake of safety, stick to investment grade bonds.
Your Takeaway
High yield bonds are securities that come with more risk than investment grade bonds. To compensate investors for the risk, issuers promise higher returns. While you should never build an entire portfolio of high risk bonds, they do have a place in a well-diversified investment strategy. As always, research each security carefully or use a trusted financial adviser.
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