High Yield Bonds, High Yield Bond

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Bonds are debt securities issued by companies, governments or municipalities in order to finance their capital expenditures. High yield bonds are debt securities that are issued by low credit quality organizations. These are organizations that have poorfinancial health and do not qualify for investment-grade ratings conferred by leading credit rating agencies, such as Standard & Poor’s Ratings Services, Moody’s Investors Service and Fitch Ratings. These credit rating agencies study the financials ofvarious companies and issue ratings based on their opinion of the probability of the firms paying interest and repaying theprincipal as scheduled. Those organizations that are associated with a high risk of default of interest or principal payment are rated below investment grade.

Since bonds are loans, the only way for organizations with below investment grade ratings to attract investors is to offer high yields, that is an interest rate that is higher than that offered by other debt instruments.

How do High Yield Bonds Work?

Most high yield bonds are traded in the over-the-counter market. Certain corporations and banks as well as governments of developing and underdeveloped nations issue high yield bonds. In the bull market of the 1990s and between 2002 and 2005, the high yield bond class produced significantly better returns than the overall stock market. However, the situation reverses quickly during bear markets. Moreover, a study by leading American investment thinker Martin Fridson, Original Issue High-Yield Bonds, made a distinction between the performance of “original issue†and “fallen angels†high-yield bonds. The study, which covered the period 1997–2006, found that bonds issued by fallen angels (organizations that were once investment grade) offered substantially higher returns than original issue bonds.

Benefits of High Yield Bonds

The benefits of high yield bonds are:

  • Favorable developments in the economy, industry or issuing company can boost high yield bond prices and result in capital appreciation.
  • High yield bonds are safer than stocks issued by the same organization. This is because if the issuing company goes bust, bond holders are repaid before shareholders.
  • Useful for diversifying an investment portfolio.
  • High yield bonds usually have a shorter maturity period and, hence, are less impacted by interest rate fluctuations thangovernment bonds.

Risks Associated with High Yield Bonds

The risks associated with high yield bonds are:

  • Economic risk: High yield bonds are extremely vulnerable to rough patches in a country’s financial climate. During periods of an economic slowdown, high yield bonds represent a high risk of a major portion of the principal being wiped out.
  • Event-based risk: Company specific risks, like changes in the management, a rise in raw material costs, market regulations and poor financial results, can lead to delayed payments or even defaults.
  • Low liquidity: It is more difficult to find buyers for high yield bonds than it is for investment grade bonds.

An investor can choose from a vast range of high yield bonds, like pay-in-kind bonds, straight-cash bonds, split-coupon bonds, floating-rate notes and zero-coupon bonds.

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