What Are High Yield Bonds

What High Yield Bonds?

All types of bonds are issued by various organizations or government bodies to raise capital for various purposes, such as funding for public service or paying-off expenditures. All bonds possess variables that determine the expected return that an investor will obtain from the purchase of their bond. Individuals make money from bonds by securing interest payments and the reimbursement of their investment when the bond matures.

In most instances, a bond that is backed by a government agency or a reputable company will yield a small return than a bond from a riskier issuer, because the repayment of the investment is either guaranteed or nearly guaranteed.

A high-yield bond is a speculative investment that possesses a low grade from a bond rating agency. Typically these bonds, which are referred to as junk bonds, are rated below investment grade at the time of purchase. As a result of the greater risk (meaning the increased likelihood that the bond will default) the purchaser of the bond will obtain a higher yield.

As a result, for the obtainment of a higher yield the individual is more susceptible to losing his investment; those issuers that are regarded as speculative possess a poor-financial model which increases the risk of default—meaning the obligation to pay the investor back is not fulfilled. To make such bonds attractive to potential investors these speculative issuers must attach a higher-yield (a higher percentage of return) to the purchasing party.

Risks Associated with High-Yield Bonds:

The holder of a high-yield bond is subject to credit risk, inflationary risk, currency risk, duration risk, interest rate risk, the repayment of principal risk, streaming income risk, liquidity risk, maturity risk, market risk, taxation adjustment risk, reinvestment risk, and political risk.

The interest rate risk attached to a high-yield bond refers to the assumed risk of the market value of the bond changing as a result of fluctuating interest levels or risk premiums. The credit risk attached to high-yield bonds refers to expected loss upon a default of the scheduled payments or the expected loss if the speculative issuer files for bankruptcy. The liquidity risk attached to a high-yield bond refers to the speculative issuer’s lack of cash, which subsequently leads to an inability to make payments on time.

Why are High-Yield Bonds used?

High-yield bonds are typically re-packaged into collateralized debt obligations; this repackaging of debt effectively raises the credit rating above the rating of the original high-yield. The increased rating enables the CDO to meet the minimum rating requirements of institutional investors and pension funds despite the high risk assumed.

High-yield bonds are often packaged into complicated derivatives as a form of toxic debt to represent a huge potential for return for a small investment.

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