High yield

What Is High Yield?

High yield refers to financial instruments, predominantly corporate bonds, that offer higher interest rates to compensate investors for a greater level of default risk compared to investment-grade securities. These bonds are typically issued by companies that have a lower credit rating due to factors such as higher leverage, unproven operating histories, or current financial difficulties¹². Consequently, they exist within the broader fixed income category of financial markets, appealing to investors with a higher risk tolerance seeking enhanced returns. The increased yield reflects the market's demand for additional compensation for taking on the elevated risk associated with these issuers.

History and Origin

The concept of lending to less creditworthy entities is not new, but the modern high-yield bond market, often referred to as the "junk bond" market, gained prominence and widespread acceptance in the United States during the 1970s and 1980s. This transformation was largely spearheaded by financier Michael Milken and the investment bank Drexel Burnham Lambert. Milken recognized the potential for companies with lower credit ratings to access capital markets by issuing bonds that offered substantially higher interest rates than those available on investment-grade debt. He successfully demonstrated that, despite their perceived risk, these bonds had acceptable default rates for their higher yield, provided they were properly researched and diversified¹¹.

Milken's pioneering efforts enabled a wave of corporate mergers, acquisitions, and leveraged buyouts in the 1980s, fundamentally changing the landscape of corporate finance. However, the rapid growth and aggressive practices associated with this market eventually led to increased scrutiny and regulatory action. In the late 1980s, investigations into insider trading and securities fraud involving prominent figures like Ivan Boesky led to charges against Drexel Burnham Lambert and Michael Milken himself. The U.S. Securities and Exchange Commission (SEC) filed a civil complaint against Drexel Burnham Lambert, documenting conspiracies and insider trading, which contributed to the passage of stricter legislation and ultimately the firm's bankruptcy in 1990¹⁰. Despite these historical challenges, the high-yield market evolved into an established capital market for raising funds.

Key Takeaways

• High-yield bonds offer higher interest rates to compensate investors for a greater risk of issuer default.
• These bonds are issued by companies with lower credit ratings, often referred to as "junk bonds."
• Investing in high-yield bonds can potentially provide higher returns but carries a greater risk of principal loss.
• The market for high-yield bonds can be more sensitive to economic cycles and overall market sentiment.
• Diversification and thorough credit analysis are crucial when considering high-yield investments.

Formula and Calculation

The primary metric for understanding high yield is the bond's yield to maturity (YTM), which represents the total return an investor can expect if they hold the bond until it matures, taking into account the current market price, par value, coupon payments, and time to maturity. The formula for yield to maturity is complex and typically requires financial calculators or software, but it conceptually solves for the discount rate that equates the present value of a bond's future cash flows to its current market price.

[
PV = \sum_{t=1}^{N} \frac{C}{(1+YTM)^t} + \frac{FV}{(1+YTM)^N}
]

Where:

• (PV) = Present Value (current market price of the bond)
• (C) = Coupon Payment (annual or semi-annual interest payment)
• (FV) = Face Value (par value) of the bond
• (N) = Number of periods until maturity
• (YTM) = Yield to Maturity

A higher YTM implies a greater expected return, but also typically signals a higher perceived risk for high-yield instruments.

Interpreting the High Yield

The yield of a high-yield bond is crucial for interpretation. A higher yield generally signifies a greater perceived risk by the market, as investors demand more compensation for holding debt issued by less stable companies. Conversely, a lower yield might indicate improving credit quality for the issuer or strong demand in the high-yield market.

When interpreting high-yield instruments, investors often compare their yields to those of risk-free assets, such as U.S. Treasuries, of similar maturity. The difference between these yields is known as the "spread." A wider spread suggests higher perceived risk in the high-yield sector, while a narrowing spread can indicate improving confidence or a "reach for yield" by investors. Changes in interest rates also impact high-yield bonds, though their prices are often more sensitive to changes in credit quality than to interest rate fluctuations compared to investment-grade bonds⁹.

Hypothetical Example

Consider XYZ Corp., a relatively new technology company seeking to expand its operations. Due to its unproven track record and higher debt-to-equity ratio, traditional lenders are hesitant to offer financing at low interest rates. XYZ Corp. decides to issue a high-yield bond with a par value of $1,000, an 8% annual coupon, and a maturity of 5 years.

An investor, Jane, purchases this bond for $950 in the secondary market. The bond's higher coupon reflects the greater risk associated with XYZ Corp. If Jane holds the bond to maturity, she will receive $80 in coupon payments each year for five years, plus the $1,000 par value at maturity. Her actual yield to maturity, considering her purchase price below par, would be higher than the 8% coupon rate. If, however, XYZ Corp. faces unforeseen financial difficulties and defaults on its payments, Jane could lose some or all of her principal investment. This scenario highlights the balance between potential higher returns and increased default risk inherent in high-yield investments.

Practical Applications

High-yield instruments are primarily used by companies that cannot access traditional, lower-cost financing due to their credit rating. They are a vital source of capital for many emerging businesses, leveraged buyouts, and companies undergoing restructuring or expansion. For investors, high-yield bonds can serve several purposes within an asset allocation strategy:

• Income Generation: The higher coupon payments provide attractive income streams, particularly in low-interest-rate environments⁸.
• Portfolio Diversification: While part of fixed income, high-yield bonds can sometimes exhibit characteristics that align more with equities, offering some diversification benefits within a broader bond portfolio.
• Growth Financing: Investors directly or indirectly support the growth of companies that might otherwise struggle to obtain funding.

Investors can gain exposure to high-yield bonds directly or indirectly through investments in mutual funds or exchange-traded funds that specialize in this asset class⁷. For example, the U.S. high-yield market saw a yield of 7.05% in June, with spreads around 296 basis points⁶.

Limitations and Criticisms

Despite their potential for higher returns, high-yield bonds come with significant limitations and criticisms. The most prominent concern is their elevated default risk. While the average annual default rate for high-yield bonds is typically 4–5%, this rate can soar during economic downturns, reaching as high as 11% during the mild recession of 1990-91 and 8% in severe downturns like 2001 and 2009. ⁴, ⁵This sensitivity to economic cycles means that the market value of high-yield bonds can decline sharply during periods of stress, leading to significant losses for investors.

Additionally, the liquidity of high-yield bonds can be lower than that of investment-grade bonds, making it more challenging to buy or sell them quickly without impacting bond prices. This illiquidity can exacerbate losses during market sell-offs. Critics also point to the fact that while high-yield bonds offer higher nominal yields, the increased risk often outweighs the additional return, especially after accounting for potential defaults and volatility. The Securities and Exchange Commission (SEC) highlights that high-yield bonds are inherently riskier because issuers may be highly leveraged or experiencing financial difficulties, and smaller or emerging companies may issue them due to unproven operating histories.
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High Yield vs. Investment-Grade Bonds

The primary distinction between high yield and investment-grade bonds lies in the issuer's credit quality and the corresponding risk-return profile. Investment-grade bonds are issued by companies or governments deemed to have a very strong capacity to meet their financial obligations, typically carrying credit ratings of BBB- (or Baa3) or higher from major rating agencies. They offer lower yields but are considered less risky due to their lower default risk and greater stability.

In contrast, high-yield bonds, also known as "junk bonds," are issued by entities with lower credit ratings (below BBB-/Baa3) or no rating at all. These issuers have a higher probability of default. To compensate investors for this increased risk, high-yield bonds offer significantly higher interest rates. The confusion often arises because both are types of corporate bonds, but their underlying creditworthiness and market behavior differ substantially, impacting their suitability for different investor objectives and risk tolerance levels.

FAQs

What determines if a bond is considered high yield?

A bond is considered high yield if it receives a credit rating below investment grade from major rating agencies. This typically means a rating of BB+ or lower (from S&P and Fitch) or Ba1 or lower (from Moody's). These ratings indicate a higher risk of the issuer defaulting on its payments.
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Are high-yield bonds always a bad investment?

Not necessarily. While high-yield bonds carry greater default risk, they can offer higher returns that may compensate for this risk, especially in favorable economic cycles. They can be a component of a diversified portfolio for investors with a suitable risk tolerance, but they require careful analysis and understanding of the associated risks.

How do interest rate changes affect high-yield bonds?

Like all bonds, high-yield bond bond prices generally move inversely to interest rates. However, high-yield bonds are often more sensitive to changes in credit quality and overall economic conditions than to interest rate fluctuations compared to investment-grade bonds. Their "spread" over risk-free rates often reflects credit market sentiment more strongly.

Can I invest in high-yield bonds without buying individual bonds?

Yes, investors can gain exposure to the high-yield market indirectly through mutual funds or exchange-traded funds that focus on high-yield debt. These funds provide diversification across many high-yield issuers, potentially mitigating the impact of any single default.¹