High Yield BondsHigh yield bonds are issued by corporations or municipalities with bad credit. Recall that a bond is a debt security issued by an entity that needs to raise money. Another way to phrase this is that a bond is a loan. The investors that buy the bond are lending money to the corporation that issued the bond. The bond is a promise to pay interest in consideration for receiving the loan and to return the principal on the maturity date. Bond issuers receive credit ratings, which reflect their ability and willingness to pay interest and repay the principal at maturity. If a bond issuer has failed on either of these tasks in the past, they will have a bad credit rating and therefore their bonds won't qualify as investment grade. Just like any other loan made to a credit risk, higher interest rates will have to be paid. For some investors, this is worth the risk that principal will be lost.
Credit Risk and High Yield BondsInvestment grade ratings end at BBB-. So any BB+ or lower rated bond is a junk bond. The lower the rating, the higher the risk of default. Ratings go through CCC (or Caa for Moody's) down to D, which is a rating given to an issuer currently in default. High yield bonds will be listed as "speculative grade" by the ratings agencies. The lower the rating, the higher the interest that will be paid.
Investing in High Yield BondsHigh yield bonds may be appealing for some fixed income investors simply because they are high yield. Although there is risk associated with these sorts of bonds, investors may find the relatively high interest payments to their liking. Moreover, with the advent of high yield bond funds (for example the SPDR High Yield Bonds ETF - JNK ), investors are able to easily spread risk across many different bonds. The SPDR high yield bonds ETF invests in 150 different bonds. Its unlikely they're all going into default. Currently the yield on this fund is close to 13% which is far better than what anyone is getting from Treasuries or Bank CDs. There are other high yield bond funds on the market. By diversifying your investment across market segments and industries instead of investing in just one or a couple of bonds, you can significantly reduce your risks. A bond ETF or mutual fund can do that for you. Types of High Yield BondsHigh yield bonds can also be classified depending on the way interest payments are handled. If a bond is a straight cash bond, regular interest payments are paid to bondholders in cash every six months until maturity. If a bond is "pay in kind", interest is not necessarily paid in cash, but could be paid in the form of other securities. Some bonds pay one interest rate for a certain time period, and a different interest rate later. These are called split-coupon bonds. Some bonds are extendable reset notes. With this type of bond, the issuer has the option of extending the maturity. In addition, the interest rate can be changed at certain time intervals or if certain events occur. In exchange for this bit of volatility, the bond holder has the option to sell the bond back to the issuer without penalty. Convertable bonds can be converted into shares of another security. A distressed security is one yielding 1000 basis points above government bonds.
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