What Are High Yield Bonds?

A bond that is issued by a company that is considered to be a higher credit risk, is know as a high yield bond, or junk bond as it is commonly referred to. The credit rating of a high yield bond is considered to be either speculative grade or below investment grade. What this means, is that the chance of default with high yield bonds is a lot higher than that of other bonds. The credit risk of high yield bonds is higher which means that the price is generally higher than other bonds of better credit quality. Thorough research has shown that portfolios of high yield bonds usually have higher returns than that of other bond portfolios, suggesting that the higher yields more than compensate for their additional added risk. These high yield bonds actually get their name from their characteristics. Credit ratings were developed for these bonds, which caused the credit rating agencies to create a grading system to reflect the relative credit quality of bond issuers. Bonds that of the highest quality are AAA then the credit scale moves down to C, and finally on down to D, or the default category. Bonds that are considered to have an acceptable risk of default are referred to as investment grade and encompass BBB bonds and higher. Those bonds that are BB grade and lower are called speculative grade and have a very high risk of default. Rule makers soon began using this demarcation to establish investment policies for financial institutions. Government regulation has also adopted these standards. Seeing as how most investors were restricted to investment grade bonds, speculative grade bonds soon developed negative connotations and were not widely held in investment type portfolios. Mainstream investors and investment dealers did not deal directly in these bonds. Because of this, these bonds became known as junk, or high yield bonds since few people would accept the risk of owning them. Prior to the 1980s, most junk bonds resulted for a decline in credit quality of former investment grade issuers. This was a result of the assumption of too much financial risk by the issuer. The advent of modern portfolio theory meant that financial researchers soon began to realize that the risk adjusted returns for portfolios of high yield bonds were quite high. What this meant is that the credit risk of these bonds was more than compensated for by their higher yields, suggesting that the actual credit losses were exceeded by the somewhat higher interest payments. High yield bond investment solely relies on credit analysis. Credit analysis is similar to equity analysis in the fact that it concentrates on issuer fundamentals. Due to the high minimum size of bond trades and the specialist knowledge in credit that is required, most investors are best advised to invest through high yield mutual funds.