Your Ultimate Guide to High-Yield Bonds
So DBS, UOB and OCBC are fighting out to raise interest rates and stay competitive so that you don’t jump ship. On the other side of the world, there is a fierce debate as to whether the Fed is going to cut its interest rates or continue with the hike.
Well, one thing we know is that interest rates now are nowhere close to what they were just a year ago, and maybe it's time that you capitalise on that.
One way you can do that is through investing in a High Yield Bond, which as the name suggests, offers higher interest rates, relative to other types of bonds.
These interest rates can be as high as 4% more than regular bonds, which makes high-yield bonds a good choice if you’re looking for substantial regular payouts from your investment.
What are High Yield Bonds?
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To first understand what a high-yield bond is, you should probably understand why a company would offer such bonds in the first place.
High Yield Bonds are usually offered by certain companies seeking to raise funds to attain greater financial stability.
| The easiest way for you to identify such companies is by paying attention to the
company’s credit rating (eg. AAA, bb, c). These ratings are given by rating agencies
(eg. Moody’s, Standard & Poor’s) based on their assessment of the company’s
financial health.
Hence a higher rating like AAA means that the company has a history of always
repaying their loans and has good financial health to repay future loans.
Likewise, a lower rating like BB or CCC usually refers to a company facing financial
instability which may not be able to fully repay its loans on time, usually due to
external market conditions.
If I were to ask you to purchase a bond from a BB company which only offers the average market interest rate on their bonds, you will probably tell me I’m crazy. However, if I told you that the company is offering an interest rate a few times that of the market rate, you might at least consider it.
That is why companies that are currently performing less than ideally offer sky-high interest rates - to give an incentive to investors to purchase their bonds.
Otherwise, such companies might find it less easy to raise funds and improve the stability of the company.
Investment Grade Bonds vs Non-Investment grade bonds
When you dive into high-yield bonds, you will also come across the terms - investment and non-investment grade bonds. Now, who decides what grade they belong to?
Image Credits: Pimco
Rating Agencies are the main source of information that investors, fund managers and issuers need, to ascertain the creditworthiness (the likelihood that the debt is paid off) of a bond issued.
These agencies are private companies that label the creditworthiness of securities including bonds, usually using a letter-based system as shown in the picture above.
Well-known examples of such agencies are Standard&Poor, Moody’s and Fitch. The role of these companies is critical as investors, rely on their ratings (to a certain extent) to make investment decisions
Fund houses will also use these ratings to decide which bonds and securities to invest in, to create the safest and most optimal portfolio.
To classify the creditworthiness of bonds more broadly, we can also use the terms ‘investment grade’ and ‘non-investment grade’.
Investment grade bonds refer to bonds which have a lower risk of defaulting and offer low-interest rates. With reference to the image above, Investment grade bonds are issued to companies with a credit rating above BBB or Baa depending on the rating agency.
Non - Investment grade bonds refer to bonds with a high risk of defaulting and offer higher interest rates. These bonds with reference to the table above, are rated BB/Ba or below, again depending on the rating agency.
Based on what you’ve learnt so far, can you guess which category High Yield Bonds fall under?
What about SGS, Convertibles, and SSBs?
You might now be wondering what’s the difference between high-yield bonds and other kinds of bonds. Some of the bonds you may have heard of are Singapore Savings Bonds (SSB), Singapore Government Securities Bonds (SGS) or even convertible bonds.
First, let’s briefly discuss each of these bonds.
Singapore Savings Bond is a government bond issued by the Singapore government for a fixed duration of 10 years. Investors in this bond will receive interest payments every 6 months. Interest rates are fixed by the Monetary Authority of Singapore.
Singapore Government Securities bond is a tradable government bond issued with the option for much longer maturity dates than SSBs. A key feature is that the interest rates are decided through an auction process.
Do check out our article on SGS bonds to know more about this process and other information about this bond!
Convertible Bonds give you the option to convert the bonds issued into shares of the issuing company, to capitalise on the growth of the stock prices.
These are issued by companies who wish to raise funds at a low cost as they can offer lower interest rates relative to regular bonds. This is possible due to the potential upside of the bonds from converting them when the underlying stock price increases.
Find out more about the advantages and disadvantages of investing in a convertible and other information here!
So what’s the difference?
The key difference here is that firstly, SSB and SGS are government-issued bonds whereas high-yield bonds are issued by companies. The Singapore government has a AAA rating therefore, it is a very safe investment thus a very low chance of the government defaulting on your bonds.
However High Yield bonds, as discussed, are issued by companies which are performing at a less-than-ideal level, so the likelihood of them defaulting on the bonds issued is higher than normal. Therefore, if you have a lower risk appetite, SSB and SGS will be better options.
| Not sure what your risk appetite is? Fret not as Techiya has the perfect solution —
a risk calculator to better know your risk profile.
The key difference then between High Yield Bonds and Convertibles is of course the interest rates. Convertibles’ key feature is that it offers a lower interest rate in compensation for the upside potential.
Hence, if you require a substantial consistent income stream from your bonds and are willing to accept the high-risk, high-yield bonds are for you.
Types of High-Yield Bonds
Image Credits: Schroders and The Business Journal
Fallen Angel
A fallen angel refers to a bond issued by a company which is entering financial instabilities and declining growth. Due to the higher likelihood of the company defaulting on its loan, its credit rating will be downgraded by rating agencies.
Therefore, the bond issued by the company will eventually be categorised as high-yield or junk bonds.
Rising Star
A rising star, however, refers to bonds issued by companies with increasing financial stability thus the likelihood of the company defaulting on its loans will decrease. This will trigger rating agencies to upgrade the credit rating of the company thus this junk bond may soon turn into an investment-grade bond.
Which should you invest in?
Actually, both types of bonds do provide good opportunities for a substantial return on investment.
Of course, the more straightforward option would be to invest in a rising star. Since a rising star already shows the potential for better financial stability, it would make sense to invest in it early on, and take advantage of the high yield and low risk.
However, fallen angels are also good investment opportunities for investors who can identify companies which have become non-investment grade temporarily.
This means that investors feel that the company’s prevailing credit rating is temporary due to one-off disruptions and thus has the potential to rise back up in the future. This allows them to take advantage of the high yields, knowing that there is the great growth potential for the company.
Effect of Interest rates on High-Yield Bonds
Image Credits: Vox
If there’s one major economic factor that affects High-Yield Bonds, it's of course market interest rates. To know why you need to first understand this statement:
Let’s understand what bond prices are. When you want to purchase a bond, you are probably not going to buy it directly from the issuing company.
Hence you will purchase it through a fund, a broker or an ETF. Thus you are effectively purchasing the bond in the secondary market or ‘second-hand’.
Thus, as with all things sold, there will be a price that your fund, ETF or broker will quote for the bond. This price changes according to the demand for the bond at that point in time (Higher Demand → Higher Price).
This demand is in turn affected by the prevailing interest rates at that point in time.
Let’s say the average interest rates rise above the interest rate offered by the bond you want to purchase. The bond thus becomes less attractive to investors who could purchase other bonds with higher interest rates.
Hence with less demand, the price of your bond will drop. The reverse thus applies when average interest rates drop below your bonds.
Advantages of High-Yield Bonds
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High payouts
This advantage of high-yield bonds may be apparent from the start but nonetheless is an important advantage of this bond. Thus if you need a substantial income from your investment consistently, and your risk appetite is high, this is the perfect solution.
Shorter maturity
A shorter maturity will work in your favour if you’re older as you would want to receive your capital sum as soon as possible so that you can tap into it for your retirement.
Furthermore, if you’re a regular investor, a short maturity also offers benefits like reduced exposure to interest rate fluctuations and possible default by the issuing company.
This works on the principle that the less time you are invested in this bond, the lower likelihood that you will incur losses from risks that comes with the investment.
Disadvantages of High-Yield Bonds
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Default Risk
This disadvantage should not come as a surprise to you as the risk of default is the main reason why you can receive such high yields.
While you or your ETF/Mutual Fund manager could make the best assessment to pick the right bond, there is still the small risk of the company defaulting on its payments.
In uncertain markets, there are various unprecedented economic factors which could push the issuing company into default. Some examples are rising inflation, supply chain disruptions and contractionary fiscal measures.
Liquidity Risk
Liquidity refers to how easily you can sell your assets for cash, on demand. With high-yield bonds, there is the possibility that when you choose to sell your bond, you might not receive compensation for the true value of the bond.
This is because the issuing company (which is in a less-than-ideal financial state), may run the risk of not being able to generate enough cash to compensate you fully when you sell your bonds.
This often occurs when a large number of bond investors choose to pull out of their investment at the same time which will be an issue for the company as they may not have enough idle cash to repay all the investors at once.
How to Invest in High-Yield Bonds
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Part of a Fund
Did you know that you can actually invest in high-yield bonds by owning them as part of a fund with a variety of securities?
This is the recommended way of investing in high-yield bonds as it helps you to limit your downside exposure due to the diversification of the portfolio with many other asset classes.
Therefore, even if a high-yield bond’s bond price starts to drop with rising interest rates or the issuing company defaults, the portfolio will often be able to make up for the incurred loss.
This is because the portfolio will be allocated with the optimal amount of high-yield bonds from different companies, and other securities so that you can enjoy the maximum upside potential.
Check out the link below on how a fund can help you to diversify your portfolio with various types of bond holdings to mitigate your risks. An upside of having a fund manage assets for you is that they can easily oversee hundreds of bonds that you and I will probably not be able to handle.
But that good diversification is only possible because they have so many teams of experts and professionals monitoring the markets and analysing the news every single day.
Click here now to see how we work with funds to bring out the best value for so many others: https://online.techiya.io/start
ETFs
Another way for you to invest in high-yield bonds directly is through an exchange-traded fund (ETF) which tracks an index of middle to low-rated bonds.
Some examples are the SPDR Bloomberg High Yield Bond ETF which tracks the Bloomberg High Yield Very Liquid index and iShares iBoxx $ High Yield Corporate Bond ETF which tracks the iBoxx USD Liquid High Yield Index.
On the note of ETFs, if you are interested in investing in ETFs tracking stocks, real estate or commodities but you’re not really sure where to start, do check out our complete guide to investing in ETFs!
Conclusion
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