Advantages and Disadvantages of High Yield Bonds

In the previous article, we understood about how high-yield bonds have emerged as one of the biggest market segments in the fixed income securities market. However, before an investor decides to commit a part of their portfolio towards high yield bonds, they must be aware of the various types of advantages and disadvantages that these bonds offer.

This article will critically evaluate the commonly stated pros and cons of the high yield bond market.

Advantages of High Yield Bonds

The main reasons which draw investors to commit their money to high yield bonds have been listed below:

• Diversification: Many investors use high-yield bonds to diversify their bond portfolio. This is because high yield bonds have very little correlation with investment-grade fixed income securities which are issued by governments as well as corporations. In fact, the movement in these bonds tends to be in the opposite direction as compared to other bonds. Hence, it makes a great addition to a portfolio of fixed income securities and ends up stabilizing the return earned by investors.

• Higher Coupon Rates: There is no doubt about the fact that the return offered by high yield bonds is quite lucrative. It is not uncommon for high yield bonds to provide annual yields which are 2 to 3 percentage points higher than regular yields. As a result, over a longer period of time, the return provided by high yield bonds can be significantly higher than the return provided by regular bonds.

• Significant Appreciation: The risk-return profile of high yield bonds are quite similar to that of equity assets. This is because the return earned from a high yield bond increases significantly if the risk profile of a company improves.

  The price of high yield bonds is not affected as much by external interest rates as by the financial position and credit rating of the firm issuing the debt. As a result, it can be said that high-yield bonds provide a significant upside potential as compared to traditional bonds. This feature lures in many investors who have a larger risk appetite.

• Lower Defaults as Compared to Equity: Now, the returns offered by high yield bonds are somewhat similar to those provided by equity. However, high yield bonds are considered less risky as compared to equities. This is because high yield bonds have a higher claim on the assets of a company as compared to equity shareholders. As a result, they would have to be paid in full before equity shareholders get any residual claim. Hence, even though defaults are quite common in high yield bonds, the risk is significantly lower when compared with equity.

Disadvantages of High Yield Bonds

There are several well-known disadvantages of high-yield bonds. Some of these disadvantages have been mentioned below:

• Callable: The biggest problem with high-yield bonds is the fact that these bonds tend to be callable. This means that investors who bear the risk may not get the opportunity to fully reap their rewards.

  For instance, a company may float an issue of high yield bonds when their financials are not in order. Over time, they may improve their credit rating and as a result, the bond value may increase.

  If the company calls the bonds at such time to avoid paying higher yields promised to the investors, then it could result in a loss to the investors. To make matters worse, the premature calling of bonds is quite common with high-yield bonds.

• Lower Liquidity: High-yield bonds are not considered to be investment grade. As a result, not many institutional investors hold these bonds. Since institutional investors form a large chunk of investors who buy and sell bonds regularly, their absence definitely impacts the liquidity in the market. Lower liquidity means that investors may sometimes not be able to sell their holdings instantaneously.

• Multiple Risks: Normal bonds only face interest rate and credit risks. However, when it comes to high-yield bonds, many more risks become relevant. For instance, investors face a risk that a credit downgrade may lead to a loss in the value of their investment. They also face risks that negative events will impact them more severely as compared to other investors.

• Higher Volatility: High-yield bonds tend to have higher volatility as compared to other bonds in the market. Analysis of empirical data has time and again shown what is already intuitively known by investors.

  Trends in empirical data clearly indicate the high yield bonds rise significantly more as compared to the average debt security in times when the market is good. However, when the overall market is bad, high-yield securities tend to be the worst. The number of defaults that happen in high yield securities tends to multiply during recessions.

• Shorter Maturity: Another disadvantage of investing in high yield maturity bonds is the shorter duration of these bonds. The shorter duration is considered to be disadvantageous since investors are not able to lock in the yields for a longer period of time. To make matters worse, the fact that a lot of high yield bonds get called before maturity makes effective maturity even shorter.

  Hence, investors who choose high yield bonds often face reinvestment risks wherein they constantly have to find newer investment options assuming that their investment will be returned to them within a short period of time.

The fact of the matter is that high-yield bonds are only suitable for seasoned bond investors who are comfortable taking large risks. The average risk-averse bond investor would be better off avoiding such an investment.