High Yield (HY) Bonds: High Returns, High Risk

High yield bonds: risky financial investments with high potential

The steady decline in interest rates over several years has led some investors to turn to fixed income securities. Among them are high yield bonds, favored by those who accept a certain level of risk.

In finance and investment, potential return is closely linked to the risk of losing the invested capital. A low-risk instrument has a low expected return, while a highly risky product generally has a high potential gain.

Among the investment vehicles, bonds are issued by companies or states. These financial securities represent a debt accompanied by an interest rate. This can be repaid in various ways, specified at the time of issuance. Once subscribed, these bonds can be resold to other investors who then receive the interest (here called the "coupon") and the repayment.

The risk associated with a bond depends particularly on its issuer. State loans are in principle associated with a low default risk. Their remuneration rate therefore serves as a market benchmark for "risk-free" investment. The more the issuer of the bond is considered to have a risk of default, the higher the interest rate associated with its bonds will have to be to attract investors: this is called the "risk premium" or the "spread" rate.

Ad

The high yield (HY) depends on the rating

Bonds can be issued by companies of all sizes, whether publicly traded or not. Those "high-yield" carry a higher risk of default, generally due to significant existing debt. However, these are not companies on the brink of bankruptcy. Large groups like Fnac Darty or Netflix have already issued "high yield" bonds. High-yield bonds, or "HY"s, are sometimes referred to as "Junk Bonds," but this interpretation is often subject to expert debate.

Analysts have noted that from 2000 to 2020, high yields have shown low volatility compared to stocks and traditional bonds, yielding a better overall performance. The ICE BofA Global High Yield Index, which tracks overall market fluctuations, has, for example, outperformed the MSCI World index, which reflects the stock market.

However, it's worth noting that past performance does not guarantee future results. Also, this index can be far removed from values taken independently from one another, which may evolve quite differently. Finally, it's important to note that the default rate on these speculative bonds can be very high. This rate can greatly fluctuate depending on the context: in 2002, the default rate was approximately 10%, it peaked at 13% in 2008, and in 2020 it soared to about 7.5%, according to Moody's default report for the period 2001-2020.

The High Yield (HY) bond is hence a high-potential financial instrument for investors as it is issued by a company with a higher risk of failure (delay or default). This risk is evaluated by credit rating agencies based on issuer solvency. For HY, it's rated below the "investment grade" (ranging from BB+ to D according to Standard & Poor's and less than Ba1 according to Moody's methodology).

High yield bonds are issued with different durations and ratings due to the diversity in security structures and the priorities of repayment in case of bankruptcy. Investors interested in high-yield bonds usually have a variety of investment options depending on their goals and risk tolerance.

Despite the risks they present, HY bonds are quite popular on the financial markets, especially in the United States and Europe. They are well-structured and benefit from development mechanisms in developed countries. However, it's important to note that the risk of capital loss is considerable: investment should be limited to a diversification strategy.

Overview of Standard & Poor's (S&P) and Moody's Rating Scales (long term)

Analyzing the risks of high yield bonds

The risk level of high-yield bonds is assessed based on the rating system. Ratings of BB, BB+, and BB- are characteristic of speculative elements with a high-risk level. Conversely, ratings of BBB+, BBB, and BBB- are medium grades, located at the bottom of the range and may include certain speculative elements. The risk in this case is lower than for BB ratings and B ratings, B+, B-, which represent a lack of desirable investment characteristics.

On their part, CCC+, CCC, and CCC- ratings are considered low-quality, very high-risk bonds. CC ratings, in turn, indicate highly speculative bonds. In sum, "high-yield" classified companies are rated less favorably on the market due to the tangible risk of default. Therefore, they gain access to loans with high interest rates to counterbalance this risk.

Moreover, inflation, increased interest charges, and other macroeconomic uncertainties can lead to downgrades in the ratings of high-yield bonds or even default of payment by the bond issuers. Compared to government bonds and investment-grade bonds, HY bonds have a lower risk of interest rate fluctuation. Issuers of these securities may make early repayments a few years after the issuance date at a predetermined price.

How to invest in high yield bonds

High-yield bonds are issued by companies whose financial stability casts doubt on repayment at maturity and even beyond. In exchange for accepting this risk, investors benefit from a better return on capital, as the interest on high yield bonds is higher.

The other advantage of these bonds is that they constitute an interesting asset class for several reasons. They serve to diversify wealth in a bond market. Several investment possibilities in these securities are available.

However, it must be clearly understood that the risk of default on repayment is real and significant. To seek a potentially high return, the investor must also consider that there is a risk he will never see his money again. Therefore, it's important to diversify capital across several HY bonds, but also across other much less risky supports. Furthermore, betting sums whose loss would have no impact on lifestyle or projects.

Direct high yield bonds

The purchase of high yield bonds directly is done through online brokers on ordinary securities accounts or through traditional banks. This form of purchase requires great expertise and a high entry ticket, it is generally not recommended for individuals. However, it does offer the possibility of avoiding the annual management fees of an investment fund.

Active or index bond funds (trackers)

The purchase of high yield bonds can also be done through investment funds so that they are placed under active or passive management. Bond funds allow for good diversification even with less capital. The fund manager can decide to buy or sell bonds according to forecasts to optimize returns while reducing risk.

HY bonds in life insurance

Life insurance is a wrapper that offers the opportunity to invest in high yield bond funds through managed or free management. The latter helps to delegate the life insurance to an expert while free management allows for self-managing the fund by choosing the units of account.

High yield bonds on ordinary securities accounts

Ordinary securities accounts (CTO) offer great flexibility in the choice of investment. However, the entrance fees on funds are non-negotiable and are charged to the investor. In addition, the choice of a good account is essential in order to benefit from a good range of referenced funds.