What are the Advantages and Disadvantages of High-Yield Bonds?
When experienced investors choose the stock market instruments, they invest in multiple asset classes beyond equities. Although certain assets can yield higher returns, they swear by diversifying their investments within the share market such that they are profitable in case one asset class goes through a bear cycle. While equity, commodities, and currencies can provide good returns, they are volatile. Hence, investors who want to ensure they earn a steady income at all times allocate a part of their capital to Bonds.
However, bonds are classified into various types, one of which is high-yield bonds. This article details everything you need to know about bonds with a special focus on the advantages & disadvantages of high-yield bonds. But first, a basic understanding of bonds.
What are Bonds?
Bonds are financial instruments that governments and private organisations use to raise money in the form of loans from the general public. Since bonds are used to seek capital from the public, they are included in the category of debt instruments. Bonds create a loan agreement between the issuer and holder, which details the terms of payment (debt servicing) and maturity. These come with a face value (principal) to be repaid on maturity and can be issued either at a discount or a premium.
Bonds are fixed-tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and dependent on various factors such as the credibility of the issuer, maturity, and interest rates in the market.
What is bond yield, and how do they rise and fall?
Before moving on to the advantages & disadvantages of high-yield bonds, it is important to understand bond yields. Typically, bond yield is attributed to the coupon rate (interest rate) that the bonds provide.
For example, a bond with a Face Value of Rs 1,000 may come with a 5% coupon rate. If you buy the bond at the face price (at par), the bond yield (the actual return on investment) would be Rs 500 as interest. However, if you buy the bond at a premium or discount from the face value of Rs 1,000, you will still get Rs 50, but the actual return percentage would fluctuate based on the actual cost of the bond.
Let’s say you purchased the bond at Rs 900. It will still pay Rs 50 as interest as the actual face value is Rs 1,000. However, your yield would not be 5% but 5.56% as you invested only Rs 900. This is the bond’s yield.
Similar to everything else in the secondary market, bond yields also depend on the supply and demand equilibrium. Bonds yield has an inverse relationship with bond prices.
For example, if you have a bond with a 5-year maturity, a 5% coupon rate and a face value of Rs 10,000. Each year the bond will pay you interest of Rs 500. Now, if the interest rates in the market rise above 5%, investors will not buy your bonds but buy the new ones that come with an interest rate higher than 5%.
As a result, you will have to lower the price of your bond to increase its yield. When you lower the price, the coupon rate increases because of the lower face value, thus increasing the bond’s yield.
What are High-yield Bonds?
High-yield bonds, also called junk bonds, are issued by companies that do not have the adequate cash flow to pay regular interest or repay the principal amount to the bondholders at the time of maturity. High-yield bonds generally have higher yields as it is only through a high yield that junk bonds can offset any risk of default. To compensate for the high risk of default, the issuer attaches a high junk bond rate to increase the yield and allow investors with a high-risk appetite to invest in the high-yield bonds. These are the common factors in understanding the advantages & disadvantages of high-yield bonds.
Advantages & Disadvantages of High-yield bonds
- High Payout: The advantages & disadvantages of high-yield bonds also include the high payout scenario. High-yield bonds do not have high investment-grade ratings. Hence, to attract investors, they come with a high coupon rate that allows investors to realise a higher yield than other types of bonds. As a result, the payout is always more in high-yield bonds throughout the tenure.
- Appreciation: Appreciation is also a factor in the advantages & disadvantages of high-yield bonds. The lower credit rating of high-yield bonds is associated with the current low cash flow of the company. However, it does not mean that the company will always have a negative cash flow. If the company successfully increases the cash flow in the future, the high-yield bond price may appreciate, giving better overall profits.
- Priority: In case the company goes through bankruptcy, the bondholders are given priority over payments. In the liquidation process, the bondholders are paid before the stockholders. Hence, it becomes a rare occurrence that the bondholders are not paid at the time of liquidation.
- Sensitivity: High-yield bonds are less sensitive to interest rate changes in the economy as they have a shorter duration. Hence, it allows for a consistent yield over the tenure of the bond.
- A fair play: High-yield bonds are indeed riskier than investment-grade bonds, but that does not imply that they will always result in defaults. Most of the high-yield bonds provide regular returns to the bondholder and rarely fail to fulfil the repayment promise along with providing higher returns.
- Default Risk: The advantages & disadvantages of high-yield bonds also include the risk of default as the company may not have adequate cash to repay the bondholders. The default risk makes high-yield bonds a riskier investment when other bonds with better credit ratings are available.
- Liquidity: Limited liquidity is also a factor in the advantages & disadvantages of high-yield bonds. As high-yield bonds are called junk bonds, most investors are hesitant to buy such bonds with the fear of default risk. Hence, it becomes tough to sell these bonds in the market.
- Credit Rating: A drop in credit rating for the bond mid-way its tenure can negatively affect the value or price of the bond. If the company sees its cash flow drop further, it may force the investors to incur huge losses.
- Recession: Recession is also a contributing factor to the advantages & disadvantages of high-yield bonds. At the time of recession, high-yield bonds are the first to go and may become worthless as the company issuing high-yield bonds is in no position to issue bonds with higher yields. This can force the investors to incur huge losses.
- Risk appetite: Investing in high-yield bonds demands that the investors have a high-risk appetite because of its risky nature. It means that the investors must be ready to lose all the capital they have invested owing to the default risk.
How to invest in High-yield bonds?
The most effective way to invest in a high-yield bond is to buy a junk bond mutual fund or an Exchange Traded Fund. Furthermore, you can also invest directly in high-yield bonds with your brokerage account. You can consult financial advisors such as IIFL to assist you with your decision to invest in high-yield bonds.
High-yield bonds may allow you to realise a better return on investment than other types of bonds. However, they may be riskier owing to their high risk of default and if the economy enters recession. Hence, it is always wise to consult a financial advisor such as IIFL to ensure you make informed financial decisions. Now that you know the advantages & disadvantages of high-yield bonds, you are better equipped to choose the right bond for you.
Frequently Asked Questions Expand All
Ans: High-yield bonds can be a good investment if you have a high-risk appetite. Although they carry a risk of default, the returns are higher than other types of bonds.
Ans: No, high-yield bonds are riskier than other investment-grade bonds but are considered less risky than the volatility seen in stocks.
Ans: You should buy a bond when you have allocated your capital in other asset classes and want to earn a steady and safer income as a part of the diversification process.
Ans: Investment grade bonds are issued by financially strong companies, while high-yield bonds are issued by financially weak companies and do not have adequate cash flow.