What are High-Yield Bonds?
The investment landscape has grown immensely over the years with plenty of financial avenues rising in the market. Thereby, creating opportunities for the individuals to augment their income levels. The market is segregated into equity and debt or bonds. People move from equities to bonds when the Stock market manifests bearish signs.
Under Bonds, one of the most popular ones is high-yield bonds. Also known as junk bonds, they add a great value to the investor’s portfolio; thus, diversifying their profile. In this article, you’ll learn about high-yield bonds, their market in India, advantages, disadvantages and a few other details with examples for better understanding.
High Yield Bonds
High Yield bonds are issued by corporate organizations to the general public. These debt security instruments carry substantial risk as the credit ratings are predominantly lower than investment-grade corporations. Companies pay a higher rate of interest on high yield bonds in India, as the default rate for high yield bonds or junk bonds is higher when compared to investment-grade bonds with high credit ratings.
The ratings for high yield bonds are given by S&P and Moody’s. The ratings for high yield bonds are BBB ranked by Standard and Poor, and Ba3 ranked by Moody’s. The probability of these high yield bonds or junk bonds getting default is high due to incessant price fluctuations. Though high yield bonds are the same as corporate bonds for debt repayment along with interest after a period, the credit rating makes a difference.
Credit ratings from BBB and over these rankings are considered investment-grade bonds holding fewer default rates. These high yield bond funds are classified into two types namely fallen angels and rising stars. Well, let’s understand these junk bonds in detail.
Fallen Angels: Initially, these bonds are investment-grade, high yield bonds funds but, the issuer’s progressively worsening financial situation led to them becoming junk bonds. In simple words, the bonds that were better rated took a downward swing in the rankings due to a slump in the issuer’s condition. These junk bonds generate higher gains than investment-grade bonds but the risk it carries is comparatively higher than the latter.
The prime cause behind the downfall of the issuer is the nosediving revenues which affected the interest payments on high yield bonds funds. It’s a double whammy effect if revenues descend along with a spike in debts. These fallen angel junk bonds are ideal for contrarian investors who like to go against the market. On the flip side, there are a set of risks involved when it comes to investing in these bonds.
Let’s say, an ABC Pvt Limited company has been performing extremely well over the years. But all their products lack innovation in the making. This opportunity was captured by a new player in the market, so they came up with a better alternative product than ABC Pvt Limited company. This results in a drop in the revenues of the ABC company.
Rising stars: These junk bonds are like the upgraded version of fallen angels. They are speculative-grade at the time of issue. Unlike fallen angels, the rising stars have a better credit rating as well. Thanks to the better financials of the issuing company. Initially, these bonds may carry the status of junk bonds, but eventually, they’ll attain an investment grade label because of the issuing company’s better credit performance.
Advantages of High-Yield Bonds
So far, you have learned about high yield bonds in India and their types. Now, let’s know their pros and cons. Below are a few benefits of why investors splurge their money in high yield bonds.
- Offers Substantial Yield: High yield bonds carry more risk compared to investment grade bonds, they offer high-interest rates to investors for the risk they are holding. They are supposed to be expecting somewhere between 150 to 300 basis points. Besides, bond issues with fewer credit ratings offer high returns to the investors. In other words, the bondholders can enjoy decent returns on their investment in junk bonds or high yield bonds.
- Generates Considerable Returns: The more the risk, the higher the reward. This goes the same with high yield bonds as opposed to investment grade quality bonds with high credit ratings and low risk. The high yield bond price doesn’t alter much despite the external interest rate fluctuations. Compared to regular bonds, junk bonds generate better returns and have upside prospects over the former.
- Diversify Investor’s Portfolio: Another pro of investing in high yield bonds in India is diversification. Not only does it shift the risk from the stock market to the debt market but also offers stable income irrespective of the company’s risk-return situation.
- Default Rate Is Low Compared To Equity: The bond market is pretty stable compared to the equity market. However, speaking specifically, high yield bonds in India produce almost the same returns as that of equities, despite high yield bonds having an upper hand when it comes to getting consistent returns over equity investors.
Disadvantages of High-Yield Bonds
Just like every coin has two sides, so is for high yield bonds as well. The cons include:
- Premature Calling of High Yield Bonds: One of the flaws of high yield bonds is that they are callable. In other words, companies can float an issue to get their financial condition back to normal. This impacts the yield rates and bond prices as well. Hence, investors may not be able to enjoy what they are promised in the beginning. This is a loss for the investors choosing high yield bonds over traditional bonds.
- Carries Default Risk: These days, default has become a very common risk for any financial instrument, be that high yield bonds or investment grade bonds. Since the credit quality ratings for high yield bonds are less, the chances of default are high. One way to reduce default risk is through diversification.
- Less Duration and Liquidity: Unlike other traditional bonds, junk bonds or high yield bonds in India have less duration. When it comes to Mutual Funds, there are funds with a good lock-in period, allowing investors to augment their income and create discipline with their investments. But, here, high yield bonds are callable, making them a less preferable choice for long-term investors.
Frequently Asked Questions Expand All
High yield bondings are junk bonds or lower credit rating bonds as opposed to investment grade bonds. Investors find this an attractive investment choice because the returns they provide are akin to that of equities.
Undoubtedly, stocks are a risky investment avenue because of the inevitable market movements and perpetual price changes. When it comes to high yield bonds, the default rate is higher than other traditional bonds with high credit ratings. Plus, these bonds carry higher interest rate risk compared to equities.