High-Yield Bond

What Is A High-Yield Bond?

High-yield bonds (HYBs), as the name suggests, have a higher yield. High-yield bonds have a higher coupon yield than investment-grade bonds. As of 2021, the stock of high-yield corporate debt was about 23% of corporate bonds, a very high proportion of corporate debt.

But as with all investments, higher returns usually represent a more significant risk. High yields on HYBs are a way of compensating investors for taking on more risk. HYBs are bonds issued by companies rated below investment grade. 

Their credit rating is below STANDARD & Poor's BBB-. Because of the company's low credit rating, they have to offer higher interest rates to attract investors' attention. Investors also know it as a "junk bond" because of its high risk of default.  

Although the band has a high default rate, it does not affect investors' attention due to its high-interest rate. These bonds have become an essential part of the financial markets.

Many individuals and institutional investors keep these bonds as part of their portfolios to reduce risk.

Understanding High-Yield Bonds

The market divides HYBs into "fallen angels" and "rising stars". Fallen Angels are bonds issued by companies with high credit ratings that have since been downgraded.

The bonds issued by these companies were also investment-grade bonds in the past, but the company was later downgraded because of credit problems. 

Rising stars are bonds issued by companies whose credit ratings are improving. Their bonds may be upgraded to investment-grade bonds in the future.  

This may be because the company was set up late and did not have the full credit backing to make its bonds investment grade. However, they may be able to issue investment-grade bonds in the future when their credit systems are perfected.  

Many people like rising Star bonds because they represent higher yields and lower risk. Some wish to find opportunities in the bonds of other fallen angels.  

In previous ratings, they were also very creditworthy companies, and some may have been temporarily downgraded for market reasons or temporary financial problems.

For investors, this is an excellent way to get high-interest rates. Companies can also make money when they meet their bond commitments in the future.

Since 1970, the ratings of many companies have been downgraded due to market factors. When companies issue bonds, they have to lower prices and raise interest rates to attract investors' attention. Since then, the HYB market has become hot.

High yield bond issuance process

When issuers issue bonds to raise money, they usually need to do some preparatory work to help themselves issue the bonds before issuing them. 

It usually involves the approval of the company's board of directors, the drafting of a prospectus, publishing the prospectus and roadshow, and the final issue of securities, which involves several steps.

1. Make a decision

Issuers of high-yield bonds are typically capital-intensive and highly indebted companies. These companies decide to issue debt to grow or keep the company going. 

This was done to raise capital and replenish the company's cash flow. The board makes the relevant bond issuance plan of the directors' system, and shareholders resolve it. When the resolution is passed, the company decides to start issuing bonds.

2. Draft the prospectus

The company began to draft its prospectus. The prospectus will include some basic information about the company as well as the total amount of the bonds and the par value of the bonds, the interest rate on the bonds, the method of servicing the bonds, and the date of issuance of the bonds.

It also discloses financial information about some companies and the risks that investors will face. Investors will use this information to understand what and when they will get a return on the money they invest in the future.  

Investors will also have a basic understanding of the company and its risks, allowing investors to weigh the pros and cons. 

When investors want to learn more about the company's industry, they can also learn from the contents of the prospectus, which includes the company's industry and its position in this industry, as well as the upstream and downstream supply situation. 

In fact, these can help investors better understand the fundamentals of the company.

3. Publicity and Trading

When the terms are finalized, the company will start a publicity campaign. 

Much of the movement now occurs through road shows with visits to well-known institutional investors, or the company can hold online or offline meetings and invite major investors to participate. At the conference, they present their bonds and explain the terms and conditions. 

The most important thing for investors is that the company will explain the current situation and financial situation of the company at these meetings.

These will give investors more information and confidence in corporate bonds. When investors have relevant questions, they can also put them forward in the meeting, and the company will answer them.

The bonds will then be issued in the secondary market, where investors can trade freely.

Advantages of High Yield Bond

For investors, the immediate benefit is that they can earn higher yields. Investors can earn higher yields than other bonds, and when a company's credit rating improves, the value of the bonds increases. 

1. Higher returns

HYBs are what they preach. They have a higher rate of return than other bonds. In other words, these companies must offer higher yields to keep investors interested in their bonds. When investors buy these bonds, they can expect higher returns.  

These bonds typically yield about two percentage points more than other bonds. This can generate considerable returns for investors.  

Even though many people are worried about the risks behind these bonds, it is more likely that these companies are paying dividends on schedule and paying higher dividends than other investment-grade companies.

2. Appreciation of bonds

Like stocks, bonds also have their trading value. When a company issues bonds through a series of efforts to improve its financial credit rating or corporate performance, investors can receive an increased return on these high-yield bonds.

Compared with ordinary investment grade bonds, high-yield bonds have tremendous potential for yield growth. As companies perform better and better, investors' confidence will increase.

The bond's trading price may then rise as investors gain confidence. So many investors choose to invest in bonds with higher yields. Adding them to your portfolio allows you to share the risk of high-yield bonds because you have many different instruments in your portfolio. 

As a matter of fact, when high-yield bonds pay dividends or appreciate in value, they can enjoy profits from appreciation or dividends.

Disadvantages of High Yield Bond

The disadvantages are also obvious, such as higher default risk, low liquidity of bonds, and more susceptibility to market sentiment resulting in volatility.

1. Higher risk

High yields on HYBs always come with increased risk. The first problem investors face is the high default rate. Companies that issue such debt have lower credit ratings than those that give investment-grade debt, which means they have a greater risk of default. 

When a default occurs, the bond will be worthless, and the investor will not receive any return. 

Secondly, people know that the bond's credit rating is low, which makes people especially sensitive to the events happening in their company. Any bad news could lead to another downgrade of their credit rating. 

Their bond prices are more sensitive to negative news than investment-grade bonds. When credit ratings were downgraded further, bond prices fell sharply. That would make investors less interested in investing. It also reduces returns for bondholders.

2. Low liquidity

Because these bonds do not have high credit ratings, they are not investment-grade bonds. Therefore, there are not as many investors in these bonds as in other bonds. 

And because these bonds are also known as "junk bonds," many investors are afraid to venture into the sector because they are too risky: which makes the bonds less liquid. It also means it is much harder for investors to resell these bonds than investment bonds. 

This further creates a barrier for investors to invest in high-yield bonds, especially for people who want to buy bonds in large amounts: if they have a lot of bonds, it will be challenging to sell those bonds at some point.

3. More vulnerable to the economic impact

High-yield bonds can attract investors' attention under their higher yields when the global economy is doing well.  

In this case, investors have strong risk resistance, so they are willing to add this bond to their portfolio to obtain higher returns, but these bonds will be the first to suffer when the economy falters.

Traditional bonds are in the market when the economy falters to attract investors by offering higher yields, but these high-yield bonds can't raise profits further, so they no longer have an advantage over investors.

Investors are more willing to choose a project with a high-interest rate and low risk rather than a high-risk project like these "junk bonds." In fact, when the economy is in recession, investors' investment risk increases. They may be more willing to withdraw from risky projects.

In the first week of May 2022, the price of America's leading junk bond exchange-traded fund (ETF) hit its lowest level in two years. The reason is fear of a future recession, which has led investors to want out of these risky investments.

Conclusion

Although high-yield bonds are also junk bonds, that doesn't mean the bond is terrible for nothing. In modern society, with the further improvement of the financial system, high-yield bonds can only represent the bonds issued by enterprises with lower credit ratings. 

Because the specific situation is different, some bonds have a higher investment profit margin. Because of the circumstances, bonds could only be issued as high-yield bonds. 

When they do, investors are lucky because they can buy higher-yielding bonds at a lower cost. And in many cases, high-yield bonds have a more stable dividend payout than the equity market, but that doesn't mean we can ignore the risks.  

We must admit that they have a higher default risk than conventional bonds because they have a lower credit rating. When the timeline is a few years or even a decade, investors need to pay close attention to what companies are doing and their ability to fulfill their contracts. 

And even if the company's operation is stable for the time being, investors need to pay attention to whether they can accept the risk of low liquidity and high volatility of such bonds. When markets are in turmoil, riskier bonds are likely to be the first to suffer. 

Therefore, conducting adequate research on the company and assessing your risk tolerance before investing in such bonds is essential. When ordinary investors are faced with all the hype and the dizzying array of bonds in the market, let's get the professionals to help us. 

When people want to invest in these high-yield bonds, they can choose some private funds, closed-end funds, and so on. Investing in riskier bonds in this way helps people spread their risk. 

Giving these bonds to professional people to help invest, they can use a more experienced perspective to help ordinary investors profit.

Investment has risks, and people should carefully consider the situation of the investment object and their situation when investing. Think twice before you invest, or let a professional investment agency help you complete your investment.

Researched and authored by Lay Shang | Linkedin

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