High-yield bonds (popularly known as “junk bonds”) are corporate debt securities that pay higher interest rates because of the low credit rating of the issuer (indicating a higher default risk).
Credit ratings are broadly classified into investment-grade rating and below-investment-grade rating.
Investment Grade
- Rated BBB- or above
- Lower Yields
- Lower Default Risk
Below Investment Grade
- Rated BB+ or below
- Higher Yields
- Higher Default Risk
A company only pays higher interest rates, when no one is willing to lend them money at a lower rate.
The risk with high-yield bonds, is that your entire capital may be lost in case of a default. This makes them much riskier than equities.
In most cases, the risk outweighs the benefit of a high yield on the bond. The risk of default, depending on the economic and industry conditions, is dynamic.
A Few Examples of High-Profile Defaults
Over 2015-20, a number of high-profile companies defaulted on their bonds, leading to large losses for investors in these securities. The image below includes some of the most notable examples:
While junk bonds are risky, it’s not synonymous with avoiding them in all cases. Very shrewd investors with a diverse portfolio of issuers, liquidity of the paper, and adequate resources usually benefit from the higher yield.
However, for the vast majority of investors, we would recommend the following:
For longer-term goals, the risk-reward of equity is far superior to the very real risk of chasing higher yield bonds or lower-quality debt funds.
For Debt MF's, make sure you understand the category that you are investing in and the accompanying level of credit-risk. While there are very low-risk debt funds, there are also some much higher on the risk-spectrum. Don't simply invest based on historical returns.