Companies and governments issue bonds to raise money, and they pay only as much interest as they have to pay to attract investors. A financially rock-solid company or government will attract investors with an interest rate that is only a little above the inflation rate. A financially troubled borrower has to offer a better deal.
- The low-yield bond is better for the investor who wants a virtually risk-free asset, or one who is hedging a mixed portfolio by keeping a portion of it in a low-risk asset.
- The high-yield bond is better for the investor who is willing to accept a degree of risk in return for a higher return. The risk is that the company or government issuing the bond will default on its debts.
In the worst-case scenario, which is bankruptcy, bondholders are first in line for repayment, but getting back all or even some of the money invested is a faint hope.
Understanding Bond Yields
Bonds make periodic payments of interest, known as coupon payments, to the bondholder. A bond's indenture–that is, its contract–details the timing and method of payment.
Key Takeaways
- The bond's rating tells you the degree of risk that the company issuing it will default on its obligations.
- The lower the rating, the higher the yield will be.
- The higher the rating, the safer your money will be.
Companies and municipalities frequently issue bonds to raise money for specific projects. It can be to their advantage to borrow the money rather than spend a chunk of the cash they have on their balance sheets.
Each bond issued is rated by one of three major rating companies, and the quality of the bond is determined by the quality of the issuer. The rating reflects the agency's opinion on the issuer's ability to make good on all of its coupon payments and return the money invested when the bond reaches its maturity.
In the investment world, any bond that is not a U.S. Treasury bond has some degree of risk, however slight.
The yield offered for the bond will reflect its rating. The higher the yield, the more likely it is that the firm issuing the bond is not of high quality. In other words, the company that issued it is at risk of default.
The Ratings and What They Mean
Three major credit rating agencies evaluate the bond issuers based on their ability to pay interest and principal as required under the terms of the bond. They are Standard & Poor's (S&P), Moody's, and Fitch Group.
- The highest S&P rating a bond can have is AAA, and the lowest is CCC. A rating of Dindicates that the bond is in default. Bonds rated BB or lower are considered low-grade junk or speculative bonds.
- Moody's ratings range from Aaa to C,with the latter indicating default. Bonds rated Ba or lower are low-grade or junk.
- Fitch ratings range from AA+ to C. Anything lower than BB- is deemed highly speculative.
High-Yield and Investment Grade
High-yield bonds tend to be junk bonds that have been awarded lower credit ratings. There is a higher risk that the issuer will default. The issuer is forced to pay a higher rate of interest in order to entice investors.
High-rated bonds are known as investment grade. They offer lower yields with greater security and a great likelihood of reliable payments.
There is a yield spread between investment-grade bonds and high-yield bonds. Generally, the lower the credit rating of the issuer, the higher the amount of interest paid. This yield spread fluctuates depending on economic conditions and interest rates.
The Old Reliable T-Bond
From the perspective of the professional investor, every bond that is not a U.S.Treasury bond (T-bond) has some degree of risk. The T-bond is the gold standard of investment-grade bonds. Its returns are notoriously low but its reliability is famously great.
On the other side of the risk spectrum, there are exchange-traded funds (ETFs) that invest only in high-yield debt. These ETFs allow investors to gain exposure to a diversified portfolio of lower-rated bonds.
This diversification across companies and sectors gives some protection against default risk. Still, a recession or a sustained period of high market volatility can lead to more companies defaulting on their debt obligations.
FAQs
The low-yield bond is better for the investor who wants a virtually risk-free asset, or one who is hedging a mixed portfolio by keeping a portion of it in a low-risk asset. The high-yield bond is better for the investor who is willing to accept a degree of risk in return for a higher return.
Is it better to buy bonds when yields are high or low? ›
Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.
Are high-yield bonds better than low 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.
Is it worth investing in high-yield bonds? ›
Key Takeaways. High-yield, or "junk" bonds are those debt securities issued by companies with less certain prospects and a greater probability of default. These bonds are inherently more risky than bonds issued by more credit-worthy companies, but with greater risk also comes greater potential for return.
Is it better to have higher or lower yields? ›
Rising yields can create capital losses in the short term, but can set the stage for higher future returns. When interest rates are rising, you can purchase new bonds at higher yields. Over time the portfolio earns more income than it would have if interest rates had remained lower.
How much is a $100 savings bond worth after 30 years? ›
How to get the most value from your savings bonds
| Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
|---|
| $50 Bond | $100 | $207.36 |
| $100 Bond | $200 | $414.72 |
| $500 Bond | $400 | $1,036.80 |
| $1,000 Bond | $800 | $2,073.60 |
Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.
Do high-yield bonds do well in recession? ›
The big deal with high-yield corporate bonds is that when a recession hits, the companies issuing these are the first to go. However, some companies that don't have an investment-grade rating on their bonds are recession-resistant because they boom at such times.
How risky are high-yield bonds? ›
Compared to investment grade corporate and sovereign bonds, high yield bonds are more volatile with higher default risk among underlying issuers.
Why invest in high-yield bonds now? ›
Additionally, the quality of high-yield bonds has improved recently, according to Northern Trust. “High yield issuers generally have become larger and more diversified, improving their ability to weather economic adversity.” In 2024, a high-yield bond could potentially be a way to diversify an investor's portfolio.
Pros and cons of a high-yield savings account
A high-yield savings account offers a higher rate of return on your money compared to standard savings accounts. But some of these accounts charge fees, have minimum balances requirements, and offer variable interest rates that can go up and down over time.
What percentage of my portfolio should be high-yield bonds? ›
Meketa Investment Group recommends that most diversified long-term pools consider allocating to high yield bonds, and if they do so, between five and ten percent of total assets in favorable markets, and maintaining a toehold investment even in adverse environments to permit rapid re-allocation should valuations shift.
How to take advantage of high bond yields? ›
You can capitalize on higher rates by purchasing real estate and selling off unneeded assets. Short-term and floating-rate bonds are also suitable investments during rising rates as they reduce portfolio volatility. Hedge your bets by investing in inflation-proof investments and instruments with credit-based yields.
What happens to bonds when interest rates fall? ›
Most bonds and interest rates have an inverse relationship. When rates go up, bond prices typically go down, and when interest rates decline, bond prices typically rise.
What are the cons of bonds? ›
Cons
- Historically, bonds have provided lower long-term returns than stocks.
- Bond prices fall when interest rates go up. Long-term bonds, especially, suffer from price fluctuations as interest rates rise and fall.
What to consider now. We suggest investors consider high-quality, intermediate- or long-term bond investments rather than sitting in cash or other short-term bond investments. With the Fed likely to cut rates soon, we don't want investors caught off guard when the yields on short-term investments likely decline as well ...
When should I buy high-yield bonds? ›
High-yield bonds tend to perform best when growth trends are favorable, investors are confident, defaults are low or falling, and yield spreads provide room for added appreciation.
Is it a good time to buy bonds? ›
That combination of relatively high yields, reasonable prices, and an expanding opportunity set may not offer the sizzle of a high-flying stock market but that may be exactly the reason to consider adding bonds to your portfolio in the months ahead.
Who benefits when yields or interest rates are high? ›
The winners. Unsurprisingly, bond buyers, lenders, and savers all benefit from higher rates in the early days.
