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 a high yield bond better than a low yield bond? ›
Due to their lower credit quality, high-yield bonds typically have a higher risk of default relative to their investment grade peers. Thus, investors require additional yield (often called “spread”) to compensate for that additional risk, although the amount of that spreads can vary widely over time.
Are high-yield bonds good investments? ›
Just because a bond issuer is currently rated at lower than investment-grade, that doesn't mean the bond will fail. In fact, in many, many cases, high-yield corporate bonds do not fail at all and pay back much higher returns than their investment-grade counterparts.
Do you want your yield to be high or low? ›
A high dividend yield can be appealing since you're getting more income per dollar invested, but a high yield isn't always a positive thing. It could mean that the company's stock price has been falling or dividend payments have been increasing at a higher rate than the company's earnings.
What are the problems with high-yield bonds? ›
A high-yield corporate bond is a type of corporate bond that offers a higher rate of interest because of its higher risk of default. When companies with a greater estimated default risk issue bonds, they may be unable to obtain an investment-grade bond credit rating.
Is higher YTM better or lower? ›
As these payment amounts are fixed, you would want to buy the bond at a lower price to increase your earnings, which means a higher YTM. On the other hand, if you buy the bond at a higher price, you will earn less - a lower YTM.
Is it better to buy bonds when yields are high or low? ›
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.
What are the risks of investing in high yield bonds? ›
While high-yield bonds do offer the potential for more gains compared to investment-grade bonds, they also carry a number of risks, like default risk, higher volatility, interest rate risk, and liquidity risk.
What are the best bonds to invest in now? ›
9 of the Best Bond ETFs to Buy Now
| Bond ETF | Expense Ratio | Yield to maturity |
|---|
| iShares 0-3 Month Treasury Bond ETF (SGOV) | 0.07% | 5.4% |
| iShares Aaa - A Rated Corporate Bond ETF (QLTA) | 0.15% | 5.3% |
| SPDR Bloomberg High Yield Bond ETF (JNK) | 0.40% | 7.9% |
| Pimco Active Bond ETF (BOND) | 0.55% | 5.8% |
5 more rowsMay 7, 2024
Rates fluctuate – Rates may move up and down, preventing you from predicting your return over time. Not the best choice for long-term savings – High-yield savings accounts offer much better interest rates than traditional savings accounts, but often, you won't earn enough over the long-term to account for inflation.
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.
Should you sell bonds when interest rates rise? ›
If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond's price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates.
Is it better to have a high or low percent yield? ›
Having a high percentage yield is good because that means the product is being created to its full capacity. This is important when performing experiments because chemists want to make sure they are being as accurate as possible and if not all their product is forming then this can cause for wrong measurements.
Why not to invest in high yield bonds? ›
What are the risks? Compared to investment grade corporate and sovereign bonds, high yield bonds are more volatile with higher default risk among underlying issuers. In times of economic stress, defaults may spike, making the asset class more sensitive to the economic outlook than other sectors of the bond market.
What happens to high yield bonds when interest rates go up? ›
When interest rates rise, prices of existing bonds tend to fall, even though the coupon rates remain constant, and yields go up. Conversely, when interest rates fall, prices of existing bonds tend to rise, their coupon remains constant – and yields go down.
Are all high yield bonds junk bonds? ›
Bonds rated below Baa3 by ratings agency Moody's or below BBB by Standard & Poor's and Fitch Ratings are considered “speculative grade” or high-yield bonds. Sometimes also called junk bonds, these bonds offer higher interest rates to attract investors and compensate for the higher level of risk.
Is a high or low Treasury yield better? ›
The higher the yields on long-term U.S. Treasuries, the more confidence investors have in the economic outlook. But high long-term yields can also be a signal of rising inflation expectations.
Does a higher bond rating mean a lower yield? ›
Lower-rated bonds generally offer higher yields to compensate investors for the additional risk.
Why are lower yield bonds more expensive? ›
The yield on a bond is its return expressed as an annual percentage, affected in large part by the price the buyer pays for it. If the prevailing yield environment declines, prices on those bonds generally rise. The opposite is true in a rising yield environment—in short, prices generally decline.
