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High-Yield Bond



Definition

A high-yield bond, also known as a junk bond, is a type of corporate bond with a credit rating below investment grade. Because of the higher risk of default associated with these bonds, they typically offer a higher yield to attract investors. The higher yield is meant to compensate for the additional risk taken on by the investor.

Phonetic

The phonetic pronunciation of “High-Yield Bond” would be: “hahy – yeeld – bahnd”.

Key Takeaways

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  1. High-Yield Bonds, also known as “junk bonds,” are corporate bonds issued by companies with a high risk of default. Because of this risk, they offer higher yields to attract investors.
  2. They represent an important part of the capital market and play a crucial role in many investment portfolios. Despite their risk, High-Yield Bonds offer diversification benefits compared to traditional equity investments.
  3. The performance of High-Yield Bonds is highly correlated to the health of the overall economy. They often perform well during economic booms but can suffer significant losses during recessions or times of high uncertainty.

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Importance

High-Yield Bonds, often referred to as “junk” bonds, are deemed critical in the finance and business field due to various reasons. Firstly, they offer a high rate of return, making them attractive investments for those able to weather potential volatility. This is because they are primarily issued by companies that have a higher risk of defaulting, hence, the elevated interest rates compared to other bond categories. This principle plays a crucial role in risk management, portfolio diversification and provides an opportunity for considerable revenue generation, especially in fluctuating economies. Furthermore, high-yield bonds also play an essential role in capital generation for companies that may not have access to other, lower-risk forms of funding, thereby providing a stimulus for business growth and development.

Explanation

High-yield bonds, also known as junk bonds, serve as a crucial financing tool for corporations that may not qualify for investment-grade bonds due to lower credit ratings. These companies might be startups with little credit history or entities with less stable cash flows or higher debt levels. By issuing high-yield bonds, they can source much-needed capital for various purposes such as expansion, acquisition, debt refinancing, or even as a financial instrument to boost their operational growth. Despite the higher risk posed to investors, the potential for higher returns make these bonds an attractive investment proposition in a well-diversified portfolio.Just as importantly, high-yield bonds play a pivotal role in the broader financial ecosystem by democratizing access to capital. They act as a bridge between firms seeking funding and the investment community willing to bear higher risk for better returns. Additionally, high-yield bonds also serve investors seeking to increase their portfolio’s yield and diversify their holdings. This asset class serves as a counterweight to lower risk, lower return investments, such as treasury or investment-grade corporate bonds, providing a cushion in an inflationary environment or periods of rising interest rates. As with any high-reward investment, these come with higher risk, and hence investors use them as part of a wider, well-balanced investment strategy.

Examples

1. Junk Bonds: “Junk bonds” is a colloquial term for high-yield bonds. These bonds are issued by companies with low credit ratings or in financial difficulty, for example, Toys “R” Us, a company that had a large amount of debt, issued high-yield bonds to investors promising high interest rates. Unfortunately, the company filed for bankruptcy and the bonds became worthless.2. Emerging Market Bonds: High-yield bonds are often associated with emerging markets. For instance, Argentina issued a high-yield bond known as the ‘Century Bond’ in 2017 due to its long 100-year maturity duration and the country’s historically unstable economic condition. It promised a high return to attract investment.3. Energy Sector Bonds: In 2014-2015, when oil prices collapsed, energy companies such as Whiting Petroleum and Chesapeake Energy had to offer high-yield bonds to raise capital. The risk involved for investors was the potential insolvency of these companies if oil prices didn’t recover.

Frequently Asked Questions(FAQ)

What is a High-Yield Bond?

A High-Yield Bond, also known as a junk bond, is a type of corporate bond with a higher risk and subsequently, higher yield than most bonds. It’s typically issued by companies with a credit rating of BB or lower, indicating a higher risk of default.

Why would an investor consider High-Yield Bonds?

Despite the higher risk, investors might consider high-yield bonds for their potential to yield substantial income. They could be quite profitable if the issuing company improves its financial standing.

What are the risks involved with High-Yield Bonds?

The primary risk is that the issuing company might default on its obligations, leading to the loss of the invested amount. Interest rate risk, credit risk, liquidity risk, and market risk are other potential risks.

How do High-Yield Bonds perform in relation to equity markets?

High-yield bonds often have a correlation with equity markets. So, if equity markets are performing well, high-yield bonds might also do well.

How can I buy High-Yield Bonds?

High-yield bonds can be purchased either individually or as part of high-yield bond funds through a brokerage account.

Are High-Yield Bonds a good addition to a balanced portfolio?

High-yield bonds can diversify a portfolio and potentially enhance returns. However, they should be balanced with safer investments considering their high risk.

Are High-Yield Bonds considered safe investments?

High-yield bonds are considered risky investments. They are generally not recommended for risk-averse investors or those with shorter investment horizons.

How is the yield of a High-Yield Bond determined?

The yield of a high-yield bond is determined by several factors, including the credit worthiness of the issuer, the duration of the bond, and the overall interest rate environment.

How are High-Yield Bonds rated?

High-yield bonds are rated by credit rating agencies like Moody’s, Standard & Poor’s, and Fitch. A bond is considered ‘high-yield’ if it is rated BB+ or lower by S&P and Fitch, or Ba1 or lower by Moody’s.

What happens if a High-Yield Bond defaults?

If a bond defaults, bondholders may lose their initial investment. Depending on the terms of the bond contract, they may be eligible to recover some of their investment through the sale of the issuer’s assets.

Related Finance Terms

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