What is a High-Yield Bond?
A high-yield bond is a corporate bond with a credit rating below BBB (also called a junk bond).
How Does a High-Yield Bond Work?
High-yield bonds are high-risk investments, and for this reason they (and the mutual funds that invest in them) have potential for higher returns than other types of bonds or bond funds.
Prices of high-yield bonds tend to be more sensitive to changes in their issuers' financial outlooks than to changes in interest rates (they actually can act as a hedge against interest rate risk), but in general, when interest rates are lower, the difference in returns among bonds of various credit ratings is larger. In other words, there is a bigger difference between what a Treasury bond might offer and what a high-yield bond might offer when market interest rates are low. This difference (the credit spread) tends to decrease when market rates are high. Thus, as interest rates fall the more attractive high-yield bonds and bond funds are to investors.
Why Does a High-Yield Bond Matter?
As you can see, bond ratings have huge influence on the price and demand for certain bonds. The lower the rating, the riskier the investment and the less the investment is worth. High-yield bonds often have less trading activity and thus liquidity problems. This is why downgrades (or rumors of downgrades) in an issuer's credit rating can have a significant impact on its bonds and on the market or industry.
High-yield bonds are not always bad, however. They simply mean there is more risk associated with the investment and thus more potential for higher returns. In fact, many income investors actively enhance their returns by dividing bonds into sectors based on certain characteristics such as credit rating, yield, coupon, maturity, etc. and then finding those sectors that will perform most favorably for the investor under certain market conditions.
