The Basics of Investing in High Yield Bonds
High-yield bonds are often referred to as “junk bonds” because they're riskier than investment-grade bonds. For some adventurous investors, their higher yields may make up for the risk.
What Are High-Yield Bonds?
High-yield bonds are the bonds issued by companies with credit ratings beneath investment-grade. Microsoft or Exxon Mobil are examples of investment-grade companies: large multinational firms with massive recurring revenues and a ton of cash on their balance sheets. In fact, both companies have higher credit ratings than the U.S. government, according to Moody's bond credit rating service, since there is no chance that they will default, or fail to make their payments on time.
In contrast, high-yield bonds are issued by companies with outlooks that are questionable enough that their debt is ranked lower than investment-grade. They might have high levels of debt, shaky business models, or negative earnings.
As a result, there is a greater likelihood that these companies could default. Therefore, they earn lower credit ratings, and investors demand higher yields to own their bonds. Bond investors use yield spread as a metric to measure the difference between the yields of different bonds.
The Risks of High-Yield Bonds
When investing in high-yield bonds, the most significant risk is credit risk—the risk that the bond issuer will default. The historical annual default rate for high yield is about 5% per year.
For people who invest in high-yield bonds via mutual funds or exchange-traded funds (ETFs), rather than individual bonds, default isn’t the primary consideration. Instead, the primary risk with those funds is a market risk due to the elevated volatility of high-yield bonds compared to other areas of the bond market. High-yield bonds have performed well over time, but the asset class can fall extremely quickly when the market environment turns sour.
For example, in 2008. the U.S. financial crisis hit the markets in full force. From August 29 to October 27 of that year, the high-yield market lost more than 25% of its value. Though that was an unusual case, it illustrates the potential short-term risks of investing in high-yield bonds.
Strong Historical Returns
Periodic sell-offs such as the one in 2008 didn't dampen the long-term performance of high yield bonds. For example, in the 10-years ending August 31, 2012, the Credit Suisse High Yield Index delivered an average annual total return of 10.26%—better than investment-grade bonds (which returned 5.48% per year on average) and U.S. stocks (which returned 6.51% per year on average, as gauged by the S&P 500 Index). Not only did high yield outperform stocks during this time, but it also did so with about half of the volatility.
In terms of yield, the asset class has averaged about six percentage points relative to U.S. Treasuries over time. However, this advantage—or yield spread—has moved within a huge range. It fell as low as 2.5–2.6 percentage points in 1997, spiked as high as 21 percentage points in the financial crisis of 2008, and dropped to four percentage points in 2019.
High-yield bonds tend to perform best during periods of economic expansion and high investor confidence. Conversely, they tend to perform poorly when the possibility of a recession is high, or investors are not comfortable taking a risk.
Who Invests in High-Yield Bonds?
High-yield bonds are generally considered to offer a middle ground between stocks and bonds. They are fixed-income securities, but with higher volatility than most segments of the bond market, and over time their performance tends to track much closer to the stock market than it does investment-grade bonds.
High-yield bonds may be appropriate for someone looking for high income but who also can withstand the risk. Most importantly, this investor should have the ability to hold on to the investment for three to five years. Due to their volatility, high-yield bonds aren’t appropriate for investors with short-term time frames or a low tolerance for risk.
How to Invest
Sophisticated investors have the option of buying individual high-yield bonds through a broker. However, this is a labor-intensive process that involves a high level of knowledge and research. Most investors choose to access this asset class via mutual funds or ETFs. Morningstar has a full list of high-yield bond funds with their historical returns—though you must create an account to view the list.
The two largest high-yield ETFs are SPDR Barclays Capital High Yield Bond ETF (JNK) and iShares iBoxx $ High Yield Corporate Bond Fund (HYG). Other ETFs that invest in the sector include:
- SPDR Barclays Capital Short Term High Yield Bond ETF (SJNK)
- iShares 0-5 Year High Yield Corporate Bond ETF (SHYG)
- PIMCO 0-5 Year U.S. High Yield Corporate Bond ETF (HYS)
- Invesco Fundamental High Yield Corporate Bond ETF (PHB)
- High Yield ETF (HYLD)
- VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL)
- First Trust Tactical High Yield ETF (HYLS)
- Toews Tactical Income Fund (THHYX)
- Invesco BulletShares 2019 High Yield Corporate Bond ETF (BSJJ)
- Invesco BulletShares 2020 High Yield Corporate Bond ETF (BSJK)
- Invesco BulletShares 2021 High Yield Corporate Bond ETF (BSJL)
- Invesco BulletShares 2022 High Yield Corporate Bond ETF (BSJM)
- Invesco BulletShares 2023 High Yield Corporate Bond ETF (BSJN)
- Invesco BulletShares 2024 High Yield Corporate Bond ETF (BSJO)
Investors also can gain access to international high-yield bonds via the following ETFs:
- iShares U.S. & International High Yield Corporate Bond ETF (GHYG)
- VanEck Vectors International High Yield Bond ETF (IHY)
- iShares International High Yield Bond ETF (HYXU)
- Invesco Global Short Term High Yield Bond ETF (PGHY)
- VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM)
- iShares Emerging Markets High Yield Bond ETF (EMHY)
The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.