While it may seem appealing to look at bonds that offer higher yields, investors should consider those higher yields to be a sign of potentially greater risk. Below are some of the potential risks involved with high yield investing.
Historically, the risk of default on principal, interest, or both, is greater for high yield bonds than for investment grade bonds. Moodys data shows that bonds rated Ba had a 2.64% probability of defaulting within a year, whereas more speculative bonds rated Caa-C, had a one-year default probability of more than 8%. Investment grade bonds meanwhile had a .03% probability of a default within a year.1
High yield bonds are subject to credit risk, which increases as the creditworthiness of the issuer falls. It’s important to pay attention to changes in credit quality, as less creditworthy bonds are more likely to default on interest payments or principal repayment.
Business cycle risk
High yield issuers typically have riskier business strategies and more leveraged balance sheets, exposing them to greater risk of default at times of a downturn in business conditions.
High yield bonds are more likely to have call provisions, which means they can be redeemed or paid off at the issuer’s discretion prior to maturity. Typically an issuer will call a bond when interest rates fall, potentially leaving investors with capital losses or losses in income and less favorable reinvestment options. Prior to purchasing a corporate bond, determine whether call provisions exist.
Some bonds give the issuer the right to call a bond but stipulate that redemption occurs at par plus a premium. This feature is referred to as a make-whole call. The amount of the premium is determined by the yield of a comparable mature Treasury security, plus additional basis points. Because the cost to the issuer can often be significant, make-whole calls are rarely invoked.
A bond’s payments are dependent on the issuer’s ability to generate cash flow. Unforeseen events could impact their ability to meet those commitments.
Excessive exposure to a specific market sector within any asset class could put investors at greater risk. It’s important to seek diversification across a wide range of issues and industries in order to reduce the negative impact of a default.
Equity correlation risk
The perception that high yield issuers may have trouble generating sufficient cash flow to make interest payments could make them behave like equities. In some cases, high yield bonds may fall along with equities during an economic or stock market downturn. This is a concern for investors using fixed income as a hedge against equity volatility.
High yield bonds that may have been easy to buy or sell when market conditions were calm can suddenly become very difficult to sell when volatility increases. Typically, the market for high yield bonds is less liquid than the market for investment grade or government bonds.
Interest rate risk
Although high yield bonds have relatively low levels of interest rate risk for a given duration or maturity compared to other bond types, this risk can nevertheless be a factor. As with all bonds, a rise in interest rates causes prices of bonds and bond funds to decline. Because credit and default risk are the dominant drivers of valuations of high yield bonds, changes in market interest rates are relatively less important. At the same time, a tightening in monetary conditions that usually accompanies a rise in the general level of interest rates may cause a lagging reaction by weaker credits because of their inability to find sufficient funding, which in turn weakens the balance sheet of the high yield entity.
Higher transaction costs
Due to a typically large spread between bid and offer prices, and higher transaction costs associated with less liquid securities, trading high yield bonds can be costly.
Research and monitoring demands
Current and accurate information can be more difficult to obtain for high yield bonds. Investors should conduct due diligence as they consider investment strategies and closely monitor the changing financial condition of the issuing company.
In addition to the risks mentioned above, there are additional considerations for bonds issued by foreign governments and corporations. These bonds can experience greater volatility due to increased political, regulatory, market, or economic risks. These risks are usually more pronounced in emerging markets, which may be subject to greater social, economic, regulatory, and political uncertainties.