What it means
The dividing line is a rating threshold rather than anything about the company's industry or size. Anything rated below the investment grade cut-off by the major rating agencies falls into the high-yield category, which includes both companies that have fallen from higher ratings and younger firms that were never rated highly.
The label describes perceived credit quality, not whether the business is well run. For a company, issuing high-yield debt is often a deliberate trade-off.
It costs more in interest than a bank loan or an investment grade bond, but it typically comes with fewer maintenance covenants and a longer maturity, giving management more room to run a plan without a lender testing ratios every quarter. Private equity buyers use it heavily to fund acquisitions for exactly that reason.
For an investor, the appeal is income and the risk is default. The extra yield over a government bond of the same maturity is called the credit spread, and it should be thought of as payment for two things: the chance of default and the fact that these bonds can be hard to sell in a stressed market.
A spread of 4 percentage points is not 4 points of extra return if defaults cost you 2 points along the way. The important nuance is how these bonds behave when the economy turns.
Investment grade bonds tend to rise when interest rates fall in a downturn, while high-yield bonds often fall, because worries about the borrower surviving outweigh the benefit of lower rates. That is why they are sometimes described as sitting between conventional bonds and shares in a portfolio.
In practice
Real-world examples.
Example
A private equity firm funds a $600,000,000 acquisition of a packaging business partly with $250,000,000 of high-yield notes at 9%. The interest bill of $22,500,000 a year is heavy, but the notes carry no quarterly leverage test, which gives the new owners three years to complete an operational turnaround.
Example
A telecoms operator is downgraded below investment grade after a large capital programme. Its existing bonds fall in price as investment-grade-only funds are forced to sell, and its next issue prices at a spread more than three percentage points wider than the previous one.
Example
A charity's investment committee holds a high-yield fund yielding 8% and is surprised when it falls 12% during a growth scare, while its government bond fund rises. The adviser explains that credit-sensitive bonds tend to move with the outlook for corporate earnings rather than purely with interest rates.
Think of it
“High-yield bond is the polite name for junk bonds-higher yields for higher risk.
Formula
Calculation
Current yield = annual coupon / market price. Credit spread = bond yield - yield on a government bond of similar maturity. Expected annual credit loss = default probability x (1 - recovery rate).
Take a bond with a face value of $1,000 paying an 8.5% coupon, so $85 a year, currently trading at $940. Current yield is $85 / $940 = 9.04%. A government bond of the same maturity yields 4.20%, so the credit spread is 9.04% - 4.20% = 4.84 percentage points.
Now allow for defaults. If the annual default probability for this rating band is 4% and lenders typically recover 40% of face value, the expected annual credit loss is 4% x (1 - 0.40) = 4% x 0.60 = 2.4%. The risk-adjusted yield is roughly 9.04% - 2.4% = 6.64%, still ahead of the government bond but by a far smaller margin than the headline coupon suggests.Case study
Seen in the real world.
This is an illustrative and fictional case. Braycliff Instruments, an invented maker of industrial sensors, needed $180,000,000 to fund a plant expansion but could not obtain a bank facility on acceptable terms after two weak quarters.
It issued seven-year high-yield notes at a 9.25% coupon, costing $16,650,000 a year in interest against operating profit of $41,000,000. The trade-off, in this fictional account, was that the notes had no maintenance covenants, so a further weak quarter would not put the company in breach and hand control to lenders.
Three years later Braycliff's margins had recovered, it was upgraded one notch, and it refinanced at 6.5%, cutting annual interest to $11,700,000. Management described the original issue as expensive insurance: they paid an extra $4,950,000 a year for the freedom to keep executing their plan without a quarterly test.
Watch out
Common mistakes.
- Reading the coupon as the expected return. The stated yield ignores defaults, and after allowing for a realistic default and recovery assumption the expected return can be several percentage points lower.
- Assuming high-yield bonds are a safe substitute for cash or government bonds because they are still bonds. They fall in value when the economy weakens, which is often the moment an investor most needs their defensive holdings to hold up.
- Believing a below-investment-grade rating means the company is failing. Plenty of large, profitable businesses sit in this category by choice, having decided that carrying more debt is worth the return on the capital it funds.
Questions
People also ask.
What is the difference between a high-yield bond and a junk bond?
Nothing; they are two names for the same thing, with "high-yield" preferred by issuers and sales desks and "junk" used more often by commentators.
Why would a company choose expensive debt over equity?
Interest is generally deductible against tax and debt does not dilute existing shareholders, so if the business can service the payments the owners keep more of the upside.
How much of a portfolio should sit in high-yield bonds?
There is no universal answer, but because they correlate with equities in a downturn, most advisers treat them as part of a portfolio's growth allocation rather than as ballast.
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