What is high yield investing?
External ratings agencies assign credit ratings to companies and governments issuing bonds based on an assessment of their credit-worthiness. This rating can help to indicate the issuers likely ability to pay interest and principal as scheduled.
A high credit rating (above BBB or Bba for Standard & Poor’s and Moody’s, respectively) is considered ‘investment grade’ while a low credit rating is considered ‘high yield’ (sometimes called ‘sub-investment grade’ or ‘junk bonds’). High yield bonds are more volatile with higher default risk among underlying issuers versus investment grade bonds. Issuers with low credit ratings need to pay higher interest as incentive to purchase their bonds. As with most investments, higher potential risks demand higher potential rewards to compensate.
The high yield bond market was born in the US and that remains the largest and most liquid market. However, today there is a global high yield market offering potential benefits such as the diversification of Europe or the stronger growth potential of emerging markets.
Why high yield bonds?
High yield bonds offer a number of potential benefits, alongside some specific risks such as higher volatility and higher default rates. In the current environment of persistently low interest rates, bond investors are finding attractive yield difficult to come by. For those in a position to take on higher levels of credit risk, high yield bonds may provide a significant yield enhancement to a well-diversified portfolio.
Higher yield and diversification
In addition to significantly higher income than investment grade bonds, high yield often behaves differently to other areas of the fixed income universe so can provide important diversification to a broader fixed income portfolio.
Equity-like return with lower volatility
There is also the potential for capital growth. Historically, the high yield market has delivered a long-term return profile broadly in-line with equities1. Like equities, high yield bond prices can increase as a result of improved performance of the issuing company or a wider economic upturn. However, the typically higher income component of high yield bonds means that they are generally less volatile than equities.
High yield bonds are typically issued with shorter maturities than many investment grade bonds (generally less than 10 years) and therefore tend to have relatively lower duration. This means a high yield strategy may be less exposed to interest rate risk than most investment grade strategies.