Are High-Yield Bonds Better Investments Than Low-Yield Bonds?

Companies and governments issue bonds to raise money and they pay only as much interest as they must to attract investors. A financially rock-solid company or government will attract investors with an interest rate that’s only a little above the inflation rate. A financially troubled company has to offer a better deal.

Key Takeaways

• A 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.
• High-yield bonds tend to be junk bonds that have been awarded lower credit ratings.

Understanding Bond Yields

Bonds make periodic payments of interest, known as coupon payments, to the bondholder. A bond’s indenture or contract details the timing and method of payment.

Companies and municipalities frequently issue bonds to raise money for specific projects. It can be to their advantage to borrow the money this way rather than spend a chunk of the cash they have on their balance sheets. Selling bonds is effectively accepting money from investors with a promise to repay that money at a future point in time plus interest.

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 its coupon payments and return the money invested when the bond reaches its maturity.

Important

Any bond that’s not a U.S. Treasury bond has some degree of risk in the investment world, 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. The company that issued it is at risk of default.

Low-Yield vs. High-Yield Bonds

A low-yield bond is better for the investor who wants a virtually risk-free asset or one who’s hedging a mixed portfolio by keeping a portion of it in a low-risk asset.

The high-yield bond is better for an investor who’s 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.

Bondholders are first in line for repayment in the case of bankruptcy which is the worst scenario but getting back all or even some of the money they’ve invested is a faint hope.

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’re Standard & Poor’s (S&P), Moody’s, and Fitch Group.

The highest S&P rating that a bond can have is AAA. The lowest is CCC. A rating of D indicates that the bond is in default. Bonds that are 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 considered highly speculative.

High-Yield and Investment Grade

High-yield bonds tend to be junk bonds that have been awarded lower credit ratings. There’s a higher risk that the issuer will default. The issuer is forced to pay a higher rate of interest to entice investors.

High-rated bonds are known as investment grade. They offer lower yields with greater security and a greater likelihood of reliable payments.

There’s a yield spread between investment-grade bonds and high-yield bonds. The lower the credit rating of the issuer, the higher the amount of interest. This yield spread fluctuates depending on economic conditions and interest rates.

How Do Coupon Payments Work?

A coupon payment equals the annual interest rate that a bond pays to an investor. The rate is calculated as the total of payments made in a year divided by the bond’s face value. Coupon payments are typically made twice a year.

When Does a Bond Reach Maturity?

The maturity date is determined and set by the bond issuer. It’s the date by which their investment capital must be returned to the investor. This can be after five years or after 12 or more years. Interest is paid to the investor in the interim.

What Is a Yield Spread?

The yield spread is the comparative difference of the yield or proceeds paid by two bonds or by two classes of bonds. The spread would be 4% if one bond yielded 2% and the other yielded 6%.

The Bottom Line

Every bond that’s not a U.S. Treasury bond (T-bond) has some degree of risk from the perspective of a professional investor. The T-bond is the gold standard of investment-grade bonds. Its returns are notoriously low but its reliability is famously great.

Exchange-traded funds (ETFs) are on the other side of the risk spectrum. They 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 but a recession or a sustained period of high market volatility can lead to more companies defaulting on their debt obligations.

Disclosure: Investopedia does not provide investment advice; investors should consider their risk tolerance and investment objectives before making investment decisions.