Are High Yield Bonds and Junk Bonds the Same?

Yes, high yield bonds and junk bonds are considered the same type of bond securities. The terms “high yield bonds” or “high yield” and “junk bonds” are often used interchangeably in the fixed income world. High yield bonds pay more than investment grade debt securities such as General Electric, Exxon Mobil, and Microsoft because they have lower credit ratings. High yield bonds typically pay more than municipal bonds. High yield bonds, like junk bonds, have a higher default risk than investment grade debt obligations.High yield is rated below BBB-/Baa3 by the three primary bond rating agencies Standard & Poor’s, Moody’s, and Fitch Ratings.

History shows that market volatility can prompt high yield debt default rates to climb. According to UPenn Wharton Finance Professor Itay Goldstein, high yield defaults can predict future financial woes. During the years of 2008 to 2009, high yield default rates rose to a high of 10.3 percent as recovery rates dropped.

Why Investors Buy High Yield Bonds

In the aftermath of the global recession that began in 2008, quantitative easing prompted interest rates to decline to historically low levels. On a risk-adjusted basis, high yield debt has averaged an annual return of almost 10 percent while the S&P returned an average of less than half that return. Investors in search of better yields on fixed income investments are attracted to high yield corporate bond yields.

Today’s high yield bond market is worth somewhere in the neighborhood of USD 3 billion—more than the stock market capitalization of Canada, France, and Germany.High yield has multiplied ten-fold in market size since 1990.

FINRA, the Financial Industry Regulatory, now tracks some high yield bonds with the FINRA TRACE system. FINRA, along with the Federal Research Bank of New York, wants to generate a better picture of the high yield bond market and trading volumes to support investors and managers who trade these securities.

High Yield Bonds: A Misunderstood Asset Class

High yield bonds trade in less than transparent over-the-counter (OTC) markets. Trading high yield bonds has increased in complexity as more hedge funds entered the market. According to “High Yield Debt: An Insider’s Guide to the Marketplace,” (2016) one fund’s high yield exposure is likely to present different results than another.

Buying high yield debt requires a deep understanding of credit analysis, volatility, recovery, interest rate risk, and defaults. For that reason, many financial experts believe individual investors should select a high yield ETF or index investment that suits their needs. There are more than 350 ETFs, closed-end funds, and mutual funds that offer investors exposure to the U.S. high yield market. Some of these investments also include exposure to distressed debt and credit spreads.

High Yield Bonds and High Yield Credit Spreads

Professional investors use high yield credit spreads to assess high yield debt values. A high yield credit spread is the percentage of difference between current yields (CY) of some classes of high yield or junk bonds in comparison to investment grade debt, Treasury bonds, and municipal securities. The five-year Treasury yield is typically one of the benchmarks used for high yield bonds.

A higher current yield in high yield debt securities reflects a greater default risk to investors than higher quality investment-rated bonds:

  • • Calculate the current yield of any bond by dividing the coupon rate by the market price. If ABC 7% 2018 bonds trade at 52 in the market, ABC’s current yield is 13.4 percent.
  • • If Merrill Lynch’s CCC-rated bond index is about 8 percent, ABC bonds reflect a high default potential.

Trading spreads of individual debt issues may also reflect higher risk in high yield debt securities. Factors such as fundamental market trends, interest rates, commodity prices, U.S. currency and more can also play a factor in the individual high yield bond issue’s trading performance.

Some high yield bond analysts say that it’s also essential to track fundamentals of the issuing company. Although high yield bonds aren’t equities, some tend to trade more like stocks than bonds.

High Yield Bond Spreads

Calculating a high yield bond spread is the simple yield difference between two high yield bonds or, sometimes, two classes of high yield bonds. Simply stated, if high yield bond A’s CY is 5 percent and high yield bond B’s current yield is 7 percent, the high yield bond spread equals two percent.

Knowing the high yield spread between two high yield bonds can help you identify investment opportunities if you’re willing to assume high levels of risk. A widening/narrowing between two high yield bond sectors or two individual high yield bonds you’re tracking can create profit opportunities:

  • To take advantage of the yield spread between two high yield bonds or sectors, buy or sell bonds in both sectors (depending on a narrow/wide spread) to generate higher returns if/when the sectors move into historical realignment.

High Yield Bond Issuer Liquidity

Investing in individual high yield bonds can be a high risk-high reward proposition. Determining the issuer’s liquidity is key to picking the best high yield bonds. Without liquidity, the issuer can’t make interest payments or return principal to bondholders on a timely basis.

Wharton research says that lack of liquidity ultimately caused higher debt issue defaults in 2008 to 2009. Investments in high yield debt were largely illiquid. AIG’s high yield debt investments ultimately prompted the need for two large TARP fund bailouts.

High Yield Bonds and Economic Indicators

A softening economy and a flight to quality securities may prompt investors to sell high yield and buy short-term investment quality debt securities. An increasing spread between the U.S. Treasury five-year bond index and high yield debt indices might predict rising rates and lower bond prices. The opposite scenario could predict lower rates and rising bond prices.

High yield and junk bonds are considered high risk debt securities and most investors don’t make a distinction between high yield and junk bonds. If you’re considering high yield bonds, evaluate these securities as carefully as possible before making an investment.