High-Yield Bonds

Why this matters

High-yield bonds sit on a border. They're bonds, with coupons and maturities and a place in the line ahead of shareholders. They're also the bonds most likely not to pay, and in a bad year they fall alongside the share market. The yields are the highest on offer in the bond market, which is exactly why they attract people who shouldn't judge them by that number. The last two lessons built the tools, default rates and spreads. This one applies them to the part of the market where they matter most.

What counts as high yield

Bonds rated below Baa3 by Moody's, or below BBB by S&P and Fitch, are considered speculative grade, or high yield. They're also called junk bonds. They pay higher interest rates to attract investors and to compensate for a higher risk of default.¹

Issuers reach this part of the market by different routes. Some are fallen angels, once investment grade and since downgraded. Others were rated below investment grade from the day they first borrowed, because they're young, or small, or in an unsteady business, or carrying a great deal of debt. Some well-known companies issue high-yield bonds, along with many lesser-known ones.¹

Three markets under one name

"High yield" suggests one kind of bond. The records suggest three.

Default and transition rates are S&P's global corporate averages for 1981 to 2023.² Spreads are index option-adjusted spreads.³

• BB is one step below investment grade. About one company in 17 defaulted within five years, and in an average year more than 4% were upgraded to BBB.
• B is the middle of the market. About one in six defaulted within five years.
• CCC and below is a different proposition. A quarter defaulted within a single year and nearly half within five. A bond here is closer to a bet on whether one company survives than to a loan.

A fund or an index described as "high yield" can be weighted toward any of these, and two with the same name can hold quite different risks. The average rating of the holdings, and the share in CCC, say more than the label.

How high-yield bonds behave

Less sensitive to interest rates

Because they generally have shorter maturities and pay higher interest, high-yield bonds are generally less affected by interest rate moves than other bonds.¹ Duration and Convexity explains why both features shorten duration. A 10-year bond with a 4.5% coupon, yielding 4.5%, has a modified duration of about 8.0. A 6-year bond with an 8% coupon, yielding 8%, has one of about 4.7. In 2022's kind of market, where the damage came from rising Treasury yields, that shorter duration is a real advantage.

More sensitive to the economy

What they lose in rate sensitivity they make up in sensitivity to credit. When the economy gets shaky, investors may rush to sell high-yield bonds and replace them with safer ones, which can push prices down. High-yield bonds also tend to move in the same direction as shares, so an investor hoping to diversify a portfolio heavy in shares may not achieve it with them.¹

The reason is in what the bondholder depends on. A Treasury holder needs nothing from the economy. A holder of a B-rated bond needs a company with little margin for error to keep earning enough to pay interest and to find new lenders when its debt comes due. Those are the same conditions shareholders depend on, so the two respond to the same news.

Harder to sell

High-yield bonds can be less liquid than investment-grade bonds.¹ As How Bonds Are Quoted and Traded described, liquidity is thinnest in stressed markets, which is when high-yield holders are most likely to want out.

The rest of this lesson is for members

Still to come in this lesson: What a high-yield portfolio earns, Reading a high-yield offer, the key takeaways, and 2 quiz questions with explanations.

Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.

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