Understanding Corporate and High Yield Bonds
Corporate and High Yield bonds are the same as government bonds except that companies issue them instead of governments. A company can issue bonds just as it can issue stock. Large corporations have a great deal of flexibility as to how much debt they can issue; the limit is whatever the market will bear. Generally a short-term corporate bond is less than 5 years, intermediate is 5 to 12 years, and long term over 12 years.
Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is they can also be the most rewarding fixed income investments because of the risk the investor must take on. The company’s credit quality is very important: the higher the quality, the lower the interest rate the investor will receive.
Corporate bonds come in two forms: investment grade and non- investment grade. Non-investment grade bonds are sometimes referred to as junk bonds or high yield bonds.
Understanding the ratings
Standard & Poors ratings for bonds determines the default credit risk of the company issuing the bond:
Investment Grade Bonds:
AAA – Extremely strong
AA – Very strong
A – Susceptible to adverse affects
BBB – Adequate protection
Non-Investment Grad Bonds
BB – Slightly vulnerable to non-payment
B – More vulnerable to non-payment
CCC – Vulnerable to non-payment
CC – Highly vulnerable to non-payment
D – Payment default
Investment grade is typically determined by a rating agency like Standard and Poors. The definition of high-yield bonds is not always consistent from source to source. With Standard and Poors, a high-yield bond is any bond below a BBB rating.
What are the risks of corporate and high-yield bonds?
When most people talk about bonds they think of lower risk investments. But what does risk really mean?
- Volatility– From day to day, week to week and even year to year, bonds can fluctuate in value just like other securities. The degree of fluctuation depends a great deal on the term of the bond and the interest rate (or coupon yield). If interest rates go down, bond values go up. The opposite is also true…if interest rates go up, bond values tend to drop. If you hold the bond to maturity, you would get the face value of the bond despite the ups and downs.
- Default risk– One of the added risks in the high-yield bond market is really in default risk. In order to avoid default risk, you must analyze the financials of the company just as if you were buying the stock. Simply put, default risk refers to the possibility of the issuing company missing payments, or worse, unable to repay the bonds. This is partly where, in the 1980’s, high-yield bonds got labelled ’junk bonds.’
- Economic Risk– High-yield bonds tend to be more sensitive to economic events than most other fixed income investments. High-yield investments tend to do better in positive economic environments. Some bond fund mangers suggest that high-yield bonds are more sensitive to the outlook of the economy and less sensitive to interest rates like normal bonds.
What are the advantages of corporate and high-yield bonds?
- Higher yields– with higher default risk, high-yield bonds must provide higher returns. When comparing different bonds, a BBB bond will provide a higher interest rate than an AAA bond.
- Diversification benefits – the high-yield bond market has emerged into an asset class of its own. It has unique characteristics so its returns have a very low correlation to both fixed income investments and equities.
- Lower interest rate sensitivity– due to the higher yields, there is lower interest rate sensitivity compared to other fixed income alternatives.
- Preferred claim to assets– since high-yield securities are a type of bond, they have prior claim to assets over common and preferred shareholders.
If you want to add high-yield bonds to your portfolio, make sure you take the time to understand the risks of default. Mutual funds may be the best way to diversify into the high-yield arena because these managers may be best equipped to do the necessary research to minimize default risk.
Consultants are now starting to recommend that pension plans should have as much as one third of the fixed income component in corporate bonds so maybe all investors should consider this recommendation in their portfolio. Corporate bonds may also be a good diversification tool for those that are concerned that interest rates may rise creating a correction in the bond market.
Do you own corporate bonds? Do you think they make sense for your portfolio?