What Are High-Yield Bonds?

All bonds are debt securities issued by organizations to raise capital for various purposes. When you buy a bond, you lend your money to the entity that issues it. In return for the loan of your funds, the issuer agrees to pay you interest and ultimately to return the face value (principal) when the bond matures or is called, at a specified date in the future known as the “maturity date” or “call date.”

High-yield bonds are issued by organizations that do not qualify for “investment-grade” ratings by one of the leading credit rating agencies—Moody’s Investors Service, Standard & Poor’s Ratings Services and Fitch Ratings. Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuer’s ability to pay interest and principal as scheduled. Those issuers with a greater risk of default—not paying interest or principal in a timely manner—are rated below investment grade. These issuers must pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks associated with investing in organizations of lower credit quality. Organizations that issue high-yield debt include many different types of U.S. corporations, certain U.S. banks, various foreign governments and a few foreign corporations.¹

¹High-yield bonds issued by foreign governments and foreign corporations will not be addressed within the scope of this booklet, which will primarily focus on high-yield bonds issued by U.S. corporations

A variety of investors participate in the high-yield bond market. They include individuals who invest in high-yield bonds through direct ownership and/or through mutual funds; insurance companies; pension funds and other institutions.

Individual investors purchase individual high-yield bonds, often as part of a well-diversified investment portfolio. They also participate in this market through high-yield bond mutual funds.

Mutual funds pool the assets of investors to create portfolios of high-yield bonds. Three separate categories of mutual funds invest in high-yield bonds:

• High-yield funds invest primarily in lower-rated bonds.
• Income mutual funds invest in a broad mix of income-producing securities, including high-yield bonds, investment-grade bonds, preferred stocks and high-dividend stocks. High-yield bonds usually represent a small portion of their holdings.
• Corporate bond funds invest mainly in investment-grade corporate issues, with a smaller allocation to high-yield bonds.

Insurance companies invest their own capital in high-yield bonds. They also participate in the market through “separate accounts” offered in variable insurance and annuity products.

Pension funds invest in high-yield bonds to earn higher rates of return than those available from investment-grade bonds, or as an alternative to investing in an issuer’s stock. Pension fund trustees are fiduciaries that must invest within “prudent man” guidelines and other considerations, which vary from state to state. Recently, in some cases, these guidelines have allowed increased pension fund participation in high-yield bonds.

Collateralized bond obligations (CBOs) are debt instruments that offer many benefits of investment-grade bonds, including current income and a high quality rating. The collateral behind these bonds often consists of a pool of high-yield bonds diversified by issuers and industries, which enables the pool to obtain a higher rating than any individual bond in the pool. CBOs may include several “tiers,” which offer different maturities, or levels of risk.

High-yield bond investors require a tolerance for risk, along with the patience to weather periodic market downturns or unexpected events that negatively impact individual issues. In addition to risk tolerance, you need access to information or professional guidance in selecting and monitoring specific issues. Some techniques for reducing the special risks of this market are to:

Diversify across issuers and industry segments You should not put all your assets in one high-yield bond. Spreading money among several issuers and industries can help reduce the risk of price declines or defaults caused by industry-specific situations/circumstances.

Adjust portfolios over economic and market cycles One of the best times to own high-yield bonds is during the expansion phase of an economic cycle, when financial measures are increasing along with consumer confidence. The worst time is during a recession, when financial measures deteriorate and investors become increasingly anxious about holding higher risk securities.

Monitor rating agencies Follow the publications of the rating agencies, which may indicate advance warnings of market difficulties. Prior to downgrading the rating of an issuer, agencies often place the company on a “creditwatch” list.

Monitor company and industry news You should follow an industry or an issuer closely—just as you would follow equities—to help anticipate factors that may impact the credit rating or the price of a bond.

A variety of investors participate in the high-yield bond market. They include individuals who invest in high-yield bonds through direct ownership and/or through mutual funds; insurance companies; pension funds and other institutions.

Individual investors purchase individual high-yield bonds, often as part of a well-diversified investment portfolio. They also participate in this market through high-yield bond mutual funds.

Mutual funds pool the assets of investors to create portfolios of high-yield bonds. Three separate categories of mutual funds invest in high-yield bonds:

• High-yield funds invest primarily in lower-rated bonds.
• Income mutual funds invest in a broad mix of income-producing securities, including high-yield bonds, investment-grade bonds, preferred stocks and high-dividend stocks. High-yield bonds usually represent a small portion of their holdings.
• Corporate bond funds invest mainly in investment-grade corporate issues, with a smaller allocation to high-yield bonds.

Insurance companies invest their own capital in high-yield bonds. They also participate in the market through “separate accounts” offered in variable insurance and annuity products.

Pension funds invest in high-yield bonds to earn higher rates of return than those available from investment-grade bonds, or as an alternative to investing in an issuer’s stock. Pension fund trustees are fiduciaries that must invest within “prudent man” guidelines and other considerations, which vary from state to state. Recently, in some cases, these guidelines have allowed increased pension fund participation in high-yield bonds.

Collateralized bond obligations (CBOs) are debt instruments that offer many benefits of investment-grade bonds, including current income and a high quality rating. The collateral behind these bonds often consists of a pool of high-yield bonds diversified by issuers and industries, which enables the pool to obtain a higher rating than any individual bond in the pool. CBOs may include several “tiers,” which offer different maturities, or levels of risk.

Some of the main attractions of the high-yield bond market for investors are:

• a high rate of current income associated with their high interest rates,
• the potential for capital appreciation if the debt is upgraded by one of the credit rating agencies, and
• precedence of legal rights over common and preferred stock in the event of the liquidation of the issuer, which affords some “cushion” of protection.

However, due to their credit quality, which is lower than that of instruments like U.S. Treasury bonds or high-grade corporate bonds, high-yield bonds involve greater risk. You should evaluate whether the returns justify such incremental risks as:

• High-yield bond prices may decline in the event of a recession.
• A bond may default if the issuer does not pay the interest or principal as required.
• A bond’s price may decline if the issuing company’s credit rating is lowered.
• A bond’s price may decline if interest rates rise.
• A bond’s price may decline because of unexpected news or financial results at the issuing company, or within the company’s industry.
• An investor may have difficulty locating a buyer at certain times, as high-yield bonds can sometimes be “less liquid” than investment-grade bonds.

Both the benefits and the risks to the investor are discussed in greater detail later.

As the high-yield market has grown, companies have become more creative with the shape and structure of bond issues. The following varieties of issues may be found in today’s market:

Straight cash bonds are the high-yield market’s “plain vanilla” bond, offering a fixed coupon rate of interest that is paid in cash, usually in semiannual payments, through the maturity or call date.

Split-coupon bonds offer one interest (coupon) rate in the early years of the bond’s life, followed by a second interest rate in later years. Split-coupon issues in which the interest rate increases in later years are also called step-up notes.

Pay-in-kind bonds allow the issuer the option of paying the bondholder interest either in additional securities or in cash.

Floating-rate and increasing-rate notes (IRNs) pay fluctuating or adjusted rates of interest based on an interest rate benchmark or a schedule of payments.

Extendable reset notes give the issuer the option of resetting the coupon rate and extending the bond’s maturity at periodic intervals or at the time of specified events. In exchange for these options, the bondholder has the right to sell, or “put,” the bond back to the issuer.

Deferred-interest bonds pay no interest to the bondholder until a future date.
Zero-coupon bonds (“zeros”) are sold at a deep discount to their face value upon issuance and pay no interest to the bondholder until accreted at maturity.

Convertible bonds may be converted into shares of another security under stated terms. The security is often the issuing company’s common stock.

Multi-tranche bonds offer bondholders several tiers of investments within the same issue. Typically, the tiers may vary in their targeted maturities and credit quality.

Over the last decade, diversity has grown among issuers that tap the high-yield market. In the late 1980s, high-yield bonds were generated by a few participants and heavily used to finance merger and takeover activities. Today, the market has broadened to include many dealers and issuers with diverse needs. Issuers of high-yield bonds can be grouped into the following categories:

“Rising stars” are emerging or start-up companies that have not yet achieved the operational history, the size or the capital strength required to receive an investment-grade rating. These companies may turn to the bond market to obtain seed capital. Although start-ups can be risky, credit rating agencies consider their lack of a track record when issuing ratings. So a start-up company that qualifies for a single-B rating should have about the same risk level as a going concern with the same rating. In some cases, bonds may offer the first chance to participate in start-ups, before these companies offer their initial public offerings (IPOs) of stock to the public. Eventually, many rising stars grow to become larger companies with top credit ratings.

“Fallen angels” are former investment-grade companies that are experiencing hard times, which cause their credit to drop from investment-grade to lower ratings. If their prospects improve, some fallen angels can regain their investment-grade status.

High-debt companies (which may be blue chip in size and revenues) leveraged with above-average debt loads that may cause concern among rating agencies. Companies refinancing debt sometimes turn to high-yield bonds to pay down bank lines of credit, retire older bonds or consolidate credit at attractive rates of interest. Companies also turn to the high-yield bond market for capital to fund acquisitions or buyouts, or to fend off hostile takeovers.

Leveraged buyouts (LBOs) create a special type of company that typically uses high-yield bonds to buy a public corporation from its shareholders, often for the benefit of a private investment group that may include senior managers. Some corporate assets or divisions may then be sold to pay down the debt.

Capital-intensive companies turn to the high-yield market when they are not able to finance all their capital needs through earnings or bank borrowings. For example, cable TV companies require large amounts of capital to acquire, expand or upgrade their systems.

Foreign governments and foreign corporations, often less familiar to domestic investors, may rely on high-yield bonds to attract capital. Bonds issued by foreign entities have not been addressed in this booklet in any detail and are not included in the statistical tables throughout. Also, it should be noted that there are other risks—currency risk and political risk—that are unique to bonds issued by a foreign government/corporation and have not been covered.