High yield bonds

In short

You have probably heard someone call a bond "junk" and walked away thinking it was not worth a second look. I want to sit with you on that a moment. A high yield bond is simply a bond where the borrower is seen as riskier, so the bond pays a higher interest rate to make it worth your while. The higher rate is the reward for taking on more chance of not getting paid back. Before you go further, know this: riskier means riskier. Understanding what that means in plain numbers is exactly what this page is for.

The whole of it

What it is

A friend of mine once compared lending money to letting a neighbor borrow your truck. If the neighbor has a great record and owns a house, you feel pretty calm. If the neighbor just moved in and you know nothing about him, you might ask for something extra in return for the risk. High yield bonds work on that same feeling. A bond is a loan. You buy it and the borrower, called the issuer, promises to pay you interest on a schedule and return your money on a set date, called the maturity date. When a credit rating agency, such as Moody's or S and P Global Ratings, looks at a borrower and decides they carry a meaningful chance of not paying back, they assign a lower credit rating. Bonds rated below a certain line are called high yield bonds or, less kindly, junk bonds. The lower rating is not gossip. It is a formal opinion based on the borrower's finances. Because the risk is higher, the issuer has to offer a higher interest rate, called a coupon, to attract buyers. That is the whole trade in one sentence.

How it works

I once watched a small town bakery try to borrow money from the bank and get turned away because the business was young. The bakery still needed cash. It found investors willing to lend at a higher rate because those investors wanted the extra income and were willing to take the extra risk. Companies that cannot get top ratings do the same thing on a bigger scale. They issue bonds into the public market. You or a fund you own can buy those bonds. Every few months, the issuer sends you an interest payment, the coupon. At maturity, you are supposed to get your original amount back, called the principal or face value. The catch is default, which means the borrower stops paying. When default happens, you may get back only part of your money, or sometimes very little. The amount you eventually recover is called the recovery rate, and it varies a great deal by situation. Bond prices also move before maturity. If investors grow nervous about an issuer, the bond's price drops on the secondary market, meaning you could sell for less than you paid if you sold early. If confidence rises, the price can go up. Interest rates in the broader economy move bond prices too. When general rates rise, existing bond prices tend to fall. High yield bonds feel that pressure but they also feel the pressure of credit worry, so two forces are always pulling at the price at once.

The numbers, and where to find yours

If you are holding a brokerage statement and wondering what the numbers mean, the one to watch first is the yield to maturity, which is the total annual return you would earn if you held the bond until it matured and the issuer paid everything promised. It folds in the coupon, the price you paid, and the time left. A second number is the spread, which is how much more the bond yields compared to a comparable Treasury bond. Treasuries are backed by the federal government and treated as the safest comparison point. A wide spread means the market sees more risk. A narrowing spread means comfort is growing. For current spread data, the Federal Reserve Bank of St. Louis publishes the ICE BofA US High Yield Index Option Adjusted Spread on its FRED database, freely available online, updated regularly. For credit ratings, Moody's and S and P Global both publish their full rating scales on their own websites at no charge, and those pages explain exactly where the high yield line falls for each agency. Reading the rating scale directly from the agency is the most reliable way to know where a given bond stands. There are no government set dollar limits on buying individual bonds in a taxable account, but contribution limits do apply if you hold bonds inside a retirement account. The IRA contribution limit for the current year is [rule:IRA contribution limit current year]. The 401k contribution limit is [rule:401k elective deferral limit current year]. The age at which catch up contributions begin is [rule:catch up contribution starting age].

A worked example

Let us follow a person named Rosa. Rosa has $10,000 she wants to put to work outside her emergency fund. She finds a corporate bond issued by a trucking company. The bond has a face value of $1,000 per bond, so she could buy 10 bonds. The coupon rate is 8 percent per year. Her purchase price on the secondary market is $950 per bond, which is below face value because investors have grown a little nervous about the trucking industry lately. She spends 10 bonds at $950, which is $9,500 total. Each bond pays $80 per year in interest, which is 8 percent of the $1,000 face value, not of the price she paid. So she collects 10 bonds at $80, which is $800 per year. If the bond matures in 5 years and the issuer pays in full, Rosa gets back $10,000, which is $500 more than she paid. Her yield to maturity is higher than 8 percent because of that extra $500 spread over 5 years. The exact figure needs a calculation a financial calculator handles in seconds. The inputs are a purchase price of $9,500, a face value of $10,000, an annual coupon of $800, and 5 years to maturity. Now suppose the trucking company defaults in year 3. Rosa recovers only 60 cents on the dollar of face value, so she gets back 60 percent of $10,000, which is $6,000 instead of $10,000. After collecting two years of coupons, 2 years at $800 is $1,600, her total back is $6,000 plus $1,600, which is $7,600 on a $9,500 investment. That is a loss of $1,900. Rosa's story shows why the coupon rate alone does not tell the whole story.

Where it goes wrong

You have probably felt the pull of a high number. Eight or nine percent sounds wonderful compared to a savings account. I understand that feeling completely. But high yield bonds go wrong in ways that are worth naming plainly. Default is the first concern. Companies that issue at high rates are under financial pressure by definition, and when the economy slows they feel it first. Liquidity is another problem. Some high yield bonds do not trade often, meaning if you need to sell fast you may find few buyers and a price you did not expect. Concentration matters too. Owning one or two high yield bonds from the same struggling industry is a very different situation than owning a broad fund with hundreds of bonds. Call risk is worth naming as well. Many high yield bonds give the issuer the right to pay you back early, called a call provision. They tend to do this when rates drop and they can refinance cheaper, which is exactly when you would prefer to keep collecting your high coupon. Finally, taxes on coupon income in a taxable account are due each year whether or not the bond has matured. The IRS treats most bond interest as ordinary income. IRS Publication 550 covers investment income and expenses, and the IRS makes it available directly on its website at irs.gov so you can read the rules that apply to your situation in the agency's own words.

Questions to answer before you leave this page

If you are weighing a high yield bond, sit with these questions honestly. What is the credit rating of the bond, and what does the rating agency's own website say that rating means? What does the default history look like for that rating category over long periods? What do the call provisions say about whether the issuer can pay you back early? How would this bond or fund sit alongside everything else you already own? What would happen to your plan if you received back only sixty cents for every dollar you lent? Is the income you would earn worth that possibility, given where you are in life right now?