Explaining High-Yield Bonds

High-yield bonds can play an important role in your investment portfolio because they have the potential to generate more income than other bonds. However, before investing your hard-earned dollars, it is important to understand how high-yield bonds work, as well as their potential risks and benefits.

How High-Yield Bonds Work

High-yield bonds, sometimes known as junk bonds, are issued by a wide range of organizations, including U.S. and foreign companies, banks, and some foreign governments. Like other debt securities, high-yield bonds are issued by organizations that need to raise money. These organization use the money from the bonds

- to help with operating costs.

- to purchase property.

- to buy equipment.

- for other business-related expenses.

Companies that require a lot of capital or that need to refinance debt sometimes turn to high-yield bonds to finance mergers, acquisitions, or leveraged buyouts.

When you purchase a bond, you are lending money to the organization that issues it to you. In essence, you are becoming a creditor of that organization. In return for your investment, the organization that issues the bond agrees to repay you the principal —or the amount you originally invested—in addition to interest by a certain date, also known as a maturity date or call date.

High Yield Bond Ratings

As with other bond types, high-yield bonds are rated by credit rating agencies like Standard & Poor's Ratings Services, Moody's Investor's Service, or Fitch Ratings. These agencies evaluate organizations and assign them ratings based on whether they think the bond issuer can pay investors interest and principal on schedule. If the rating agencies believe an issuer is at greater risk of defaulting on its obligations or not paying in a timely manner, the organization is rated below investment grade. For example, Standard & Poor's highest bond rating is “AAA,” but bonds considered non-investment grade can be rated anywhere from a “BB” to a “D.” High-yield bonds are issued by organizations that do not qualify for an investment grade rating.

To attract investors, organizations that lack investment grade ratings must offer higher returns to investors. Just as individuals with poor credit ratings have to pay higher interest rates on mortgages, credit, and other loans, bond issuers with non-investment grade ratings have to pay more interest on their bonds. In most cases, bonds are considered a safer investment than stocks, but high-yield bonds can be an exception to this rule. In fact, in some cases, they are considered riskier than stocks.

Benefits

Depending on your financial goals and your tolerance for financial risk, there are some reasons to consider including high-yield bonds in a diversified portfolio. High-yield bonds:

typically offer higher interest rates than Treasuries or investment-grade corporate bonds. They also tend to provide a higher rate of income.
have the potential for capital appreciation if the bond issuer's rating is upgraded due to an economic upturn or an improvement in the organization's overall performance.
are generally not tied to sectors affiliated with fixed income markets—an advantage when it comes to diversifying your portfolio.
offer greater protection to the investor in the event of the bond issuer's bankruptcy or liquidation. In the case of either of these events, bondholders—essentially creditors of the organization—take precedence over stockholders and get paid first.
offer less interest rate volatility risk than long-term U.S. Treasury bonds. Generally speaking, the longer it takes a bond to mature, the more vulnerable its price is to fluctuations in the interest rate. High-yield bonds usually are callable after four or five years even though they are usually issued with maturities of 10 years or less.

Risks