High-yield bonds offer yields close to 10-year highs but carry a greater risk of default than investment-grade bonds. Does it make sense to invest?
High Yield Bonds, also known as High Yield Bonds or Speculative Bonds, represent financial instruments issued by companies or entities with a lower credit rating than investment grade bonds, i.e. those issued by companies, government entities, or sovereign entities trusted by major rating agencies such as Standard & Poor’s (S&P), Moody’s and Fitch Ratings.
The credit rating plays a fundamental role as it represents an assessment of the creditworthiness and ability of a company or an issuer to honor its debt obligations. High-yield bonds, typically rated "Bb" or lower by S&P or "Ba" or lower by Moody’s, carry a higher risk than investment-grade bonds, making them less attractive to the eyes of investors.
Because of the greater risk, high-yield bonds offer higher returns than investment-grade bonds. Companies that issue high-yield bonds are usually in more critical financial situations than those considered most reliable.
Investors should be fully aware of the heightened uncertainty and should carefully evaluate the issuer’s financial condition and associated risks before considering an investment in High-Yield Bonds.
Why returns are at a 10-year high
Over the past 10 years, returns on high-yield bonds have approached all-time highs, sparking increasing interest among investors. As a result, companies with high credit risk are turning more and more attention to this financing instrument to improve their debt financial structure.
This trend is particularly evident in Europe, where "Yield to Worst" yields (the total annual return obtained if the bond is repaid at the cheapest possible price before maturity) have almost reached a 10-year high. Investment Grade bonds have an average yield of 4.1%, while High Yield bonds offer an attractive 7.4% annual yield, albeit not at an all-time high. In the case of Global High Yield bonds, considered riskier, it even reached 9% for YTWs.
Rising interest rates had a significant impact on the financial environment, but it was the increased risk of default that pushed yields on these bonds higher. The default risk level is around 3%, lower than the historical average for High Yield bonds, which stands at 5%. Despite this, many experts are concerned about the upward trend in interest rates in the US and Europe. This could have a negative impact on these bonds’ prices.
At the same time, an increase in interest rates could lead to an increase in default rates. This is due to the increase in companies’ difficulties in successfully implementing debt refinancing operations, especially for the most financially damaged entities. This is because the cost of refinancing could conceivably be higher when the currently outstanding bonds mature. As many experts predict, interest rates will remain relatively stable in the near future or at least not deviate too much from current levels.
So, what more than anything else could trigger a dramatic increase in high yield bond yields would be a medium to large market shock, an unforeseen event or unpredictable variable, commonly known as "Black Swan".
Does it make sense for an investor to take this risk?
Investors should be aware of business dynamics and carefully evaluate the associated risks before making investment decisions. This applies to all bonds: for example, even though the risk is generally lower, investment-grade bonds can still pose problems, as even rating agencies can make mistakes. While such events are rare, they may occur in exceptional situations or as a result of unforeseen changes in business or market conditions. Some notable examples include cases such as Enron, Lehman Brothers, and General Motors.
In summary, the choice to invest in high-yield bonds depends on the investor’s needs, investment objectives, and risk profile. Investors looking for a higher yield might consider high-yield bonds as part of a diversified portfolio. However, it is crucial to understand that these bonds are issued by companies with a lower credit rating, which implies a higher risk of default. This means that the issuer may not be able to pay interest or repay the principal to investors.
For this reason, many experts recommend diversifying your bond portfolio High Yield by investing in issuers from different sectors and regions in order to reduce the specific risk associated with a single issuer or sector. However, it remains crucial to carry out a diligent assessment of issuing companies, considering their financial situation and carefully assessing the associated risks.
Original article published on Money.it Italy 2023-06-20 16:24:05. Original title: Investire in High Yield, rendimento vicino ai massimi di 10 anni
