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High-Yield Bond: Definition, Types, and How to Invest

Imagine a company that needs quick funding to grow, maybe to launch a new product, expand into a new market, or upgrade its operations. But what if this company doesn’t have the strongest credit rating? Traditional lenders or conservative investors might hesitate to provide capital. To overcome this, the company offers bonds with higher interest rates to attract those willing to take on more risk. These are known as high-yield bonds, often referred to as “junk bonds” because of the lower credit rating of the issuer.

For investors, high-yield bonds can be appealing because they offer the potential for higher returns compared to traditional, safer bonds. However, they also come with greater risk, making it essential to understand what they are, the different types available, and how to approach investing in high yield bonds effectively. With the right knowledge and strategy, these bonds can diversify your portfolio and enhance your earning potential.

What Are High-Yield Bonds?

High-yield bonds are debt securities issued by corporations or entities with lower credit ratings, typically below investment grade, “BB” or lower. To compensate investors for the increased credit risk, these bonds offer higher interest rates compared to investment-grade bonds.

Think of high-yield bonds as a trade-off between risk and reward. Companies issuing these bonds often need quick funding for expansion, restructuring, or other financial needs. Because their creditworthiness isn’t top-tier, they offer higher returns to attract investors. This is why the high yield bond market plays a crucial role, giving such companies access to capital while providing investors with opportunities for potentially higher earnings. 

For an investor, this means the chance to earn more than they would with safer bonds, but with the understanding that there’s a higher possibility of default. Whether these bonds are right for you depends on your risk tolerance, financial goals, and strategy for investing in high-yield bonds.

Types of High-Yield Bonds

Understanding the various types of high-yield bonds is important for constructing a well-rounded investment approach. Here are the key categories:

  • Fallen Angels: These are bonds that were previously investment grade but have been downgraded due to changes in the issuer’s financial health.

  • Rising Stars: These are speculative-grade bonds showing signs of improving creditworthiness and may be on the verge of being upgraded to investment-grade.

  • Secured High-Yield Bonds: Backed by specific assets as collateral, providing investors with some protection if the issuer defaults.

  • Unsecured High-Yield Bonds: Not backed by specific collateral; investors rely only on the issuer’s creditworthiness, hence these are riskier.

  • Non-Convertible Debentures (NCDs): Fixed-income instruments with specific tenures and fixed interest rates, not convertible into company equity. NCDs typically cater to investors seeking stable, predictable returns with relatively higher interest rates compared to convertible debentures. Some NCDs are classified as high yield if the issuer has lower credit ratings.

  • High-Yield Corporate Bonds: Issued by companies, especially those in capital-intensive sectors or with higher leverage.

  • Small Cap Bonds: Bonds issued by smaller or emerging companies, often categorised as high yield due to their higher risk profile.

With Bondbazaar, you get access to over 10,000 bonds, far more than most competitors who list fewer than 100. This wide selection lets you choose the perfect balance between risk and return for your portfolio.

How to Invest in High-Yield Bonds?

There are several ways to start investing in high yield bonds, depending on your risk appetite and investment goals:

1. Direct Purchase of Individual Bonds

Investors can buy high-yield bonds through broker-dealers in the primary or secondary market. However, buying individual high-yield bonds can be risky, as default risk is significant for a single issuer.

2. High-Yield Bond Funds and ETFs

For most retail investors, high-yield mutual funds and exchange-traded funds (ETFs) are a practical choice. These funds pool money to buy a diversified portfolio of high-yield bonds, spreading risk and reducing individual default exposure. They are also more liquid, making it easier to buy and sell shares compared to holding individual bonds.

3. Non-Convertible Debentures (NCDs)

NCDs offer higher interest rates and are ideal for income-seeking investors. They can be purchased during public issues or in the secondary market. Assessing the credit rating and financial health of the issuer is critical before investing.

Benefits of High-Yield Bonds 

High-yield bonds offer several advantages that can make them an attractive option for certain investors:

  1. Higher Income Potential: These bonds pay higher interest rates, leading to better cash flow and potentially higher returns.
  2. Portfolio Diversification: They behave differently from traditional bonds, helping spread risk across asset classes.
  3. Opportunities in the High Yield Bond Market: Provide access to growing or restructuring companies often unavailable in safer markets.
  4. Potential for Capital Appreciation: Bond values may rise if the issuer’s financial health improves.
  5. Inflation Hedge: Higher coupon payments help offset inflation’s impact on purchasing power.

Bondbazaar’s real-time trading platform is directly connected to NSE and BSE, making bond investing as seamless and liquid as equities. You can buy and sell bonds with a click, ensuring you’re never locked into an investment when you need funds.

Investment-Grade Bonds: AAA Bonds

The least risky investment is called AAA Bonds and is supported by the highest credit ratings (the AAA credit rating) as rated by agencies such as CRISIL, ICRA, or Fitch. These bonds have a low tendency to default, they yield relatively stable returns and are highly liquid. This contrast helps investors align their portfolio with their risk appetite.

Key Considerations Before Investing

  • Credit Ratings: Always check the credit rating of bonds before investing. Lower ratings mean higher yield and higher risk.
  • Diversification: Avoid concentrating investments in a single issuer or sector.
  • Investment Horizon: Match bond maturity and risk level to your financial goals.
  • Professional Advice: Consult financial experts or use managed funds for informed decision-making, especially if you’re new to high-yield bonds.

Conclusion

Investing in high-yield bonds can provide opportunities for enhanced income and diversification, but it’s crucial to balance these benefits against the inherent risks. By understanding the types of high-yield bonds, their risk-reward tradeoff, and smart ways to invest, you can make choices that strengthen your portfolio’s potential while staying aligned with your financial objectives.