High-Yield Bonds: Definition, Types, Risks, and How to Invest

High-yield bonds, commonly called junk bonds, are corporate debt securities that pay higher interest because the issuing companies have lower credit ratings. They offer potential for higher returns than investment-grade bonds but carry greater risks, especially the risk of default. These bonds are often issued by startups, turnaround companies, or firms with heavy leverage.

Key takeaways

• High-yield bonds pay higher yields to compensate for lower credit quality and higher default risk.
• Non-investment-grade status is generally Ba1 or lower (Moody’s) or BB+ or lower (S&P/Fitch). BBB (S&P/Fitch) and Baa3 (Moody’s) are the lowest investment-grade ratings.
• Main risks: default, higher volatility, interest-rate exposure, and liquidity constraints.
• Retail investors typically reduce risk by investing through diversified high-yield mutual funds or ETFs rather than holding individual bonds.

What is a high-yield bond?

A high-yield bond is a corporate bond rated below investment grade by major rating agencies. Issuers promise periodic interest payments and return of principal at maturity, but lower creditworthiness increases the chance that they will miss payments (default). Credit ratings range from investment grade (higher credit quality) to speculative grade (lower quality); they guide expected credit risk and yields.

Types: fallen angels and rising stars

• Fallen angels — Bonds that were once investment grade but were downgraded to non-investment-grade because the issuer’s credit profile weakened.
• Rising stars — Bonds that currently carry speculative ratings but whose issuers’ credit quality is improving, potentially moving them toward investment grade.

Why investors choose high-yield bonds

• Higher income — Yields are typically greater than on investment-grade bonds.
• Diversification — Can offer uncorrelated return drivers within a broader fixed-income or multi-asset portfolio.
• Upside in economic expansions — Defaults and credit spreads often tighten during economic growth, improving returns.

Main risks

• Default risk — The most significant risk. If an issuer defaults, bondholders can lose some or all principal and interest.
• Volatility — High-yield bond prices move more like equities than investment-grade bonds and can be significantly more volatile.
• Interest-rate risk — Bond prices generally decline when market interest rates rise; longer maturities are more sensitive.
• Liquidity risk — Lower-rated issues can be harder to sell quickly at a fair price, especially in stressed markets.
• Credit-spread risk — Changes in the extra yield demanded for credit risk can materially affect prices.

Investment approaches

Options for gaining exposure to high-yield bonds:
* Individual bonds — Buying specific corporate issues through broker-dealers allows control over maturity and the ability to construct bond ladders, but requires credit research and can concentrate default risk.
* Mutual funds and ETFs — Provide diversification across many issuers, professional management, and easier trading (ETFs). They reduce single-issuer default risk but introduce management fees and potential liquidity considerations at the fund level.

What to consider when choosing a fund or bond:
* Credit-quality mix and average rating
Duration and maturity profile (interest-rate sensitivity)
Expense ratio and fees
Manager track record and turnover
Yield-to-maturity and spread over benchmarks

Retail investors often favor diversified high-yield funds or ETFs to mitigate default and liquidity risks inherent in individual junk bonds.

How rising interest rates affect high-yield bonds

When nominal interest rates rise, bond prices generally fall because new issues offer higher coupons. For high-yield bonds specifically:
* Price declines can occur as investors demand higher yields.
* However, rising rates often coincide with stronger economic growth, which can reduce default risk and narrow credit spreads—partially offsetting rate-driven price declines.
Net effects depend on the balance between higher benchmark rates and improvements (or deteriorations) in issuer creditworthiness.

FAQs

What is a non-investment-grade bond?
A non-investment-grade bond (high-yield or junk bond) carries a lower credit rating and higher expected default risk in exchange for higher yields compared with investment-grade bonds.

Are BBB bonds investment grade?
Yes. BBB (S&P/Fitch) and Baa3 (Moody’s) are the lowest tiers of investment-grade ratings. Bonds below those levels (e.g., BB+ or Ba1 and lower) are considered non-investment-grade.

Bottom line

High-yield bonds can enhance income and return potential but require a higher tolerance for credit risk, price volatility, and liquidity variability. For most individual investors, diversified mutual funds or ETFs are the most practical way to access the asset class, while those with the resources to conduct credit research and accept concentrated risk may consider individual issues. Evaluate your financial goals, time horizon, and risk tolerance before investing in high-yield bonds.