As its name suggests, a high-yield bond (also known as a junk bond) is a bond that offers high yields in exchange for a higher risk of defaulting (i.e. a greater returns from interest rather than principal).

In the U.S., there are three principal credit rating agencies: S&P, Moody’s, and Fitch Ratings. These companies rate bonds according to the probability of default together with the probability of not receiving interest and principal subsequent to a default (i.e. credit risk).

For example the scale used by S&P and Fitch is: AAA, AA, A, BBB, BB, B, CCC, CC, C, and D (sometimes consisting of sub-categories). Bonds that are rated AAA by S&P are considered “prime, maximum safety”, and most government bonds fall into this category.

A credit rating BBB or higher indicates that the bond is investment grade, while a credit rating lower than BBB indicates that the bond is non-investment grade, or junk (hence the alternative title of high-yield bonds).

Some institutional investors (e.g. pension funds) are prohibited from investing in bonds below a particular grade level.

For companies whose bonds have been rated investment grade, a downgrade to “junk” status can be a difficult situation. Not only will newly issued bonds now require significantly higher interest payments, but the relatively narrow market for junk bond issues can make them higher to sell. A bond with a credit rating that has dropped below investment grade is commonly referred to as a “fallen angel”.

High-yield bonds play an important role in some investment strategies. A common strategy involving high-yield bonds is merger arbitrage. In a merger, an acquirer would issue junk bonds to help finance an acquisition, after which the acquirer would use the acquired target’s cash flow to pay the debt over a period of time.

For many industries, junk bonds are an important source of capital.

Some recommended reading: Beyond Junk Bonds by Glenn Yago and Susan Trimbath. This book is a very comprehensive guide to the high-yield market in general. Includes case studies of actual firms and securities in the industry, as well as comparisons to the private/public equity, and fixed income markets.

Another highly recommended title, written by an authority on distressed debt and bankruptcy, is: Bankruptcy, Credit Risk, and High Yield Junk Bonds by Edward I. Altman. Includes a dedicated section to High Yield “Junk Bonds and Distressed Securities, and articles from other scholarly contributors around the world.



Thanks to Gary Spitz for contributing this article to our Bonds blog:

Cashing In Savings Bonds

Can you answer Joe B’s question about Bonds?:

Besides the fact that in general, interest on municipal bonds is not taxable in the USA but it is in Canada, please answer the following questions:

1) Please explain if municipal bonds are easily available to individual investors in the USA, and what the smallest denomination or amount is (or are US municipal bonds generally only available to large institutional investors).

2) Are US municipal bonds constantly being issued, or is there a limit as to how much debt a municipality can sell before they hit a wall and can’t issue any more bonds?

3) In the US, are municipal bonds highly desired (leading to a shortage of bonds) or are they plentiful and easily attainable?

4) What is the current interest rate of US municipal bonds?

5) Municipal bonds don’t seem to be available AT ALL in Canada. Can someone explain why? Are they issued only rarely - and only to large institutional investors? Are municipalities (cities, etc) prevented (by law) from running budget deficits in Canada, hence why municipal bonds are rarely seen?

High Yield Corporate Bonds

Before we can answer the question “should you invest in individual bonds or bond mutual

funds”, we have to first understand the purpose of owning bonds in your portfolio. Novice

investors use bonds as an income generator, relying on yields to supplement living expenses

during retirement. Institutional investors and competent advisors, on the other hand, view

bonds as a tool to reduce portfolio volatility. Total return, not just bond yield, is what counts. If the purpose of holding bonds is to control portfolio risk, then owning bond funds, not individual bonds, is the appropriate choice.

Individual bond shares are not cheap. A single corporate bond can cost you $10,000 or more.

So, if a retiree with a million dollars decides to allocate 40% of his portfolio to bonds

($400,000), he would likely have to purchase at least forty different issues to achieve a

somewhat diversified bond portfolio. The higher costs associated with acquiring individual

bond issues may prevent many investors from sufficiently diversifying among different issues.

In contrast, an initial investment in a bond fund might cost only $1,000 to $3,000 depending on

if you purchase it in a retirement account or not. As a bond fund holder you can own stakes in

dozens, perhaps hundreds, of bonds with one purchase. Let’s take for example the Vanguard

Short Term Bond Index (VBISX). If you own an IRA, you can hold 642 distinct bond positions

with a $1,000 investment in the fund—a far cry from the 40 issues we purchased in the

previous example.

Costs

While individual bonds do not incur the ongoing management and operating expenses of bond

funds, they do have associated expenses including brokerage commissions/fees and bid-ask spreads) that all investors should consider. Furthermore, retail investors (as most of us are)get less favorable pricing (commissions AND bid/ask spreads) than institutional investors. The

costs of trading individual bonds are very hard to accurately pin down and commissions are

never fully disclosed. If ever there was an area for institutional traders to make obscene profits

in the markets, it’s the bond market.

When you purchase a bond fund, you know what the cost will be: a transaction fee and the expense ratio. There are a handful of low priced bond funds available, including the Vanguard

Bond index we discussed above whose annual expense is only 0.20%.

Safety

Many investors are under the impression that owning bonds is a risk-less transaction. That is a myth that results in a false sense of security. The fact is that bonds, whether corporate or treasury respond to daily changes in interest rates as well as credit conditions. Individual bond investors might take comfort in knowing that at the end of the maturity period, their principal will be returned. However, throughout the maturity period, their principal will fluctuate. As interest rates rise, bond principal will go down (since the bonds become less attractive to new investors). If the owner of the individual bond feels compelled to sell their position before the maturity date, they may likely take a loss during a period of rising interest rates.

Bond funds are much more liquid. Granted, bond funds do not have a fixed maturity (meaning

principal nor income is guaranteed). But, fund managers are constantly buying and selling

bonds within the portfolio in order to maximize interest income and capital gains.

Additionally, if you only own forty bond issues in your portfolio, having one or two of them

default can put a serious damper in your day. In contrast, because a bond fund holds

hundreds of bond issues, if a handful of them default the impact might be nonexistent.

The Benefits of Indexing

By now I hope I’ve convinced you that bond funds are more attractive than individual bond

issues. But, what type of bond fund should you buy?

There is a strong argument in favor of owning bond index funds instead of actively managed

bond funds. In general, bond index funds offer you broad bond market exposure for a fraction

of the cost of an active fund. All other things equal lower expense ratios result in higher returns for you. Furthermore, with actively managed funds, investors assume an additional level of risk: manager risk.

In conclusion, there are distinct benefits to owning bond funds in lieu of individual bonds.

Despite their ongoing expense, bond funds provide a better alternative in terms of diversification, liquidity, and the availability of reinvesting dividends. A low cost low cost bond index fund will help you achieve the portfolio risk control you need. Remember, just as with equity investments, the more broadly you diversify, the better results you will attain.



Thanks to Cathy Pareto for contributing this article to our Bonds blog:

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