What is the theoretical and practical meaning of high yield bonds? Here is the definition and investment implications of so-called "junk" securities.
The high yield bonds market is a significant player in the global financial landscape, with a value exceeding $2 trillion. The universe of these securities includes over 3,200 issues from 1,500 different companies. The issuers of these instruments, also known as "junk bonds", have credit ratings lower than "BBB-" by S&P or "Baa3" by Moody’s.
In fact, high yield bonds stand out for offering some of the highest returns in the bond market; however, they carry greater credit risk. Unlike investment grade bonds, these securities tend to have shorter maturities, generally less than 10 years, and have shown high volatility during significant events such as the 2008 crisis, the 2011 euro crisis, the 2020 pandemic and the war in Eastern Europe in 2022.
Let’s try to better understand what high yield bonds are and how they work, examining characteristics, risk-return profiles and concrete methodologies for structuring informed investments in this asset class.
What are high yield bonds: meaning and definition
High yield bonds are a specific category in the bond market, characterized by issuers with high capital intensity and significant levels of indebtedness. To give a summary definition, we can say the following.
High-yield bonds, often called "high-yield bonds" or "junk bonds," are debt instruments issued by companies or entities with credit ratings below investment grade, typically BB+ or lower according to rating agencies such as Standard & Poor’s, Fitch or Moody’s. These securities are characterized by offering significantly higher yields than bonds issued by issuers with high financial strength, thus compensating for the higher credit risk associated with them.
The higher yield is a direct result of the risk perceived by investors, which includes a higher probability of default by the issuer. Companies issuing high-yield bonds are often companies in the process of growth, restructuring or operating in highly volatile sectors, which need access to capital but do not have a track record of stability sufficient to obtain a high rating.
Differences with investment grade bonds
High yield instruments, also called sub-investment grade, occupy the riskiest segment of the credit spectrum. Distinctive characteristics include:
- short duration, rarely more than 10 years;
- high yield premium for the risk taken;
- performance more aligned with the stock market compared to investment grade securities.
investment grade issuers qualify as consolidated companies, with reliable business models and capital strength. Here is the rating system and relative classification:
| Category | S&P/Fitch rating | Moody’s rating |
|---|---|---|
| Investment Grade | BBB- and above | Baa3 and above |
| High Yield | BB+ and below | Ba1 and below |
The global high yield market today encompasses a wide range of issuers, from well-known giants such as Netflix and Jaguar Land Rover to small and medium-sized companies that are new to the bond markets. However, it is important to note that a downgrade from ’BBB-’ to ’BB+’ can have significant repercussions, as it indicates that the company may quickly encounter difficulties in repaying its debt.
How to Invest in High Yield Bonds
High yield bonds can be an attractive option for investors seeking higher yields in a low interest rates environment, but they require careful consideration of the risk/return profile.
One of the key aspects to consider is the credit spread, or the yield differential between the high-yield bond and a government bond of the same duration. This spread reflects not only the default risk of the issuer but also market factors such as liquidity and general economic conditions.
From a technical point of view, high-yield bonds work like any other bond: the investor lends money to the issuer in exchange for a flow of interest (coupons) and the repayment of the capital at maturity. However, in periods of economic difficulty or increased risk aversion, the market for these bonds can be subject to strong volatility, both due to an increase in defaults and a reduction in liquidity in the secondary market.
To manage the associated risks, institutional and private investors tend to diversify their portfolio of high yield bonds across different sectors and regions. In addition, it is essential to monitor metrics such as:
- the average default rate of the high yield market;
- the debt/EBITDA ratio of issuers;
- the global macroeconomic outlook.
All elements that directly influence the performance of these financial instruments.
Original article published on Money.it Italy. Original title: Obbligazione high yield, cosa sono e come investire
