High yield bonds: risks and opportunities

High yield bonds are issued by companies rated below BBB- (Baa3 for Moody's). They pay higher coupons and yields because investors take on a greater risk that the issuer will not be able to pay.

They are sometimes called "speculative grade" bonds. The higher return is real, but it comes with risks that do not show up in the yield figure itself, and it is worth understanding them before comparing numbers.

This guide explains where the extra yield comes from, the main risks that come with it, why the bands within high yield differ so much from each other, and what to check before comparing one bond with another.

Why they yield more

The extra yield over government bonds, the spread, compensates for three things: the probability of default, the expected loss in the event of default, and the lower ease of selling the bond. When the economy slows, high yield spreads widen quickly and prices fall: these bonds behave partly like shares.

This means that the yield you see is not a measure of what you will earn but of what the market asks to be paid for the risk. Part of that extra yield is, on average, used up by the defaults that do occur.

The main risks

• Default: this is the biggest risk. A single default can wipe out years of coupons if the portfolio is poorly diversified.
• Liquidity: many issues are small and rarely traded; the difference between buying and selling price can be wide.
• Early redemption: many high yield bonds are callable; if rates fall the issuer can repay them and the expected yield is not achieved.
• Downgrade: a further cut in the rating makes the price fall.

These risks often show up together: in a downturn, downgrades become more frequent, spreads widen and the bonds become harder to sell, all at the same time.

Not all high yield is the same

The BB band is the closest to investment grade and has historically had far fewer defaults than the B and CCC bands. On 10BONDS the lowest rating you can select is BB: the more speculative bands and unrated bonds never appear.

The step from investment grade to BB is the first one down the scale, and it is a very different step from the one between B and CCC.

How to compare them

Before the yield, look at the rating, the duration and the seniority. Compare the spread with that of similar issuers: if a bond yields much more than others with the same rating, the market sees a specific risk. The guide on credit risk explains how to read it.

The bond finder shows the highest yields every day, one bond per issuer. For a comparison with stronger issuers, look at bonds with a yield of around 5% and a higher minimum rating.

Keep in mind that a callable bond may be repaid before maturity: for these bonds the yield to maturity is not the only figure that counts.

How much weight to give to high yield

It depends on your situation, your objectives and how much risk you can bear: it is a choice to make with a licensed adviser. In general one rule applies: the higher the yield you are looking for, the more important it is to diversify across many issuers.

Diversification matters more here than anywhere else in the bond market, because the risk of a single issuer is larger and a single default weighs more on the result.

Find your 10 bonds: move the rating slider down to BB and compare the yields.