 Personal Finance PowerPoint Presentation High-Yield Bond Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia High-Yield Bond, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chin, updated October 23rd, 2020. In prior presentations, we've been looking at investment goals, investment strategies, investment tools, keeping them in mind, we're now asking, what are high-yield bonds? High-yield bonds also called junk bonds or bonds that pay higher interest rates because they have lower credit ratings than investment grade bonds. So quick recap on the bonds in general, when we're thinking about investing, we're often thinking about diversifying our portfolio, putting some of our investments perhaps into stocks, equities, putting some of our investments possibly into bonds. When we think about the bonds, the first item or the first issuer of bonds that may come to mind is often government bonds, and that's a great measuring tool for us because the government bonds have very little risk with regards to default risk, and so they can be a good tool to measure other bonds against. So the bond in essence means that we're basically kind of loaning money to the issuer of the bond if we're purchasing it from the issuer. If it were the government, then we'd be giving them in essence money, they'd be giving us basically a promise to repay the money plus some interest on it. Typically, if we're buying it from a corporation, similar kind of thing, we would give the corporation money and they would be giving us a bond in essence, a promise to give us the money back plus interest, interest in essence being similar to say rent. For example, if we were being renting someone an apartment, we would expect the apartment to be returned at the end of the rental period and rent to be earned on the use of the apartment. Interest is the use of basically the purchasing power of money and the rent on that. So now we're basically looking at the corporate bonds. When we go on the corporate bonds side of things, then they're usually going to be more risky than the government bonds because the government bonds has the capacity to tax and even print money. If you're talking about the US government, so they should be able to service their debt, the large corporations are going to be quite likely to be able to service their debt even though they don't have the taxation power and then smaller companies are going to have less likelihood that they're going to be able to service their debt and therefore they're generally going to be also having a higher return possibility related to them. That's where we are here. So high yield bonds are more likely to default, so they must pay a higher yield than investment grade bonds to compensate investors. So if you think about this from a market perspective, if I was able to put my money and give my money to someone who's almost guaranteed not to default, very little risk on the default risk like the government, then that's where I would put my money all else equal. And then if the large corporations have very low risk, they're going to have to pay a little bit more in interest in order to compete with the government bonds that have even lower risk. And then when you talk about smaller companies, if they're going to issue their bonds, they're going to have to give you a higher interest rate in order to invest in them because they're inherently more risky than investing in larger companies or government bonds. So higher risk, we would expect a bigger return related to it. So issuers of high yield debt tend to be startup companies or capital intensive firms with high debt ratios. So in other words, if you're a startup company, if you think about the curve of a company as they grow, a company that succeeds, many companies will fall off at some point, but a company's growth spurt, if they reach their full growth spurt, you would think that they're going to have a growing perspective or a growing phase and it's going to be substantial where they grow at a higher rate, buying factories, buying equipment and so on, which will hopefully generate revenue in the future. That's when they need more capital. That's when they need more money in essence. That's when they might want to be issuing the bonds in order to finance basically those operations. So however, some high yield bonds are fallen angels that lost their good credit ratings. So you've got fallen angels, their credit ratings are going down. That's going to make it more difficult to get capital, to get funding. Understanding high yield bonds. From a technical viewpoint, a high yield or junk bond is pretty much the same as a regular corporate bond since they both represent debt issued by a firm or corporation with a promise to pay interest and return the principal at maturity. Same kind of thing with general bonds except now it's not a government bond. It's a company bond and you're talking about basically the risk related to different types of corporations. Junk bonds typically being more risky corporations that you're investing in. Junk bonds differ because of their issuers poorer credit quality. All bonds are characterized according to this credit quality and therefore fall into one of two bond categories. High yield and investment grade. High yield bonds carry lower credit ratings from the leading credit agencies. The credit agencies are going to hopefully help us to determine the credit ratings which will help us to determine the risk which will help us to determine our investment strategies, investment goals and what kind of return we would expect upon those types of investments. So a bond is considered and just note that these investment rating agencies are a great tool. They're not perfect because we have seen issues where the credit rating agency had high credit ratings and they weren't accounting for complex securities and so risk was higher than had been expected. But hopefully those are trustworthy indicators. So a bond is considered speculative and will thus have a higher yield if it has a rating below BBB from S&P or below BAA3 from Moody. So there's three agencies they got similar kind of rating characteristics but they're not exactly the same. Bonds with ratings at or above these levels are considered investment grade. Credit ratings can be as low as D currently in default and most bonds with C ratings are lower carry a higher risk of default. High yield bonds are typically broken down into two subcategories. You've got the fallen angels. This is a bond that was once investment grade but has since been reduced to junk bond status because of the issuing companies poor credit quality. So the angel was once an angel and has now then fallen as is the tragic story that we've seen before. So we got the rising stars though the opposite of a falling angel. This is a bond with a rating that has been increased because of the issuing bonds improving credit quality. A rising star may still be a junk bond but it's on its way to being investment grade. We may still be a junk bond but we're coming that trash can we're at the top of the heap and shooting right past that dirty napkin. So advantages of high yield bonds so higher yields generally investors in high yield bonds can expect at least 150 to 300 basis points in additional yield compared to investment grades bonds at any given time. So in other words if you're if you're investing in the more riskier bonds you're doing so because you're expecting them to compensate with a higher a higher return on it. So they might default that's a problem but they couldn't have the higher return. If you're thinking about usually people that are investing they're often thinking about not so much going into the junk bonds. Oftentimes they're probably thinking about using bonds as a hedge against their kind of equity investments but possibly more towards if you have a lot of bonds and you're looking for income streams then you know you might get more mixed up in the in the different sorts of bonds but just note oftentimes in a general investment strategy you might be looking not so much at the junk bonds but trying to use your bonds as kind of a hedge and therefore using possibly more secure bonds in that sense. So in actual practice the gain over investment grade bonds is lower because there will be more defaults. Mutual funds and exchange traded funds ETFs provide ways to tap into these higher yields without the undue risk of investing in just one issuers junk bonds. So if you put your money into like mutual funds and ETFs that's going to be things where they pool the funds together and then invest in various different junk bonds now even though you're in junk bonds that have a higher default risk you're now investing in kind of a diversified area within the junk bonds area and so you have a little bit of diversification within that class so that could be a strategy to basically use in your overall investment strategy. So higher expected returns while high yield bonds suffer from the negative junk bond image they actually have higher returns than investment grade bonds over most long holding periods. For example the iShares iBox dollar high yield corporation bond that's the ETF HYG had an average annual total return of 6.44% between beginning 2010 and the end of 2019 during that time the iShares iBox dollar investment grade corporate bond ETF LQD returned an average of 5.93% per year. This result is in accord with modern portfolio theory MPT which holds that investors must be compensated for higher risk with higher expected returns. Disadvantages of high yield bonds default risk. Default is itself the most significant risk for high yield bond investors the primary way of dealing with default risk is diversification but that limits strategies and increases fees for investors. With investment grade bonds investors can buy bonds issued by individual companies or governments and hold them directly. When they hold bonds directly investors can build bond ladders to reduce interest rate risk. So the interest rate risk is basically the risk that as you're holding on to bonds which has basically the fixed rate of return generally that interest rates go up it's kind of like the market rates are going up and therefore if you had the money if you weren't locked into the bonds to some degree you might be able to invest the money as the interest rate goes up in similar investments getting a greater return. One of the way to deal with that if you're purchasing different kind of fixed rate investments is to try to stagger the maturity dates as you purchase the bonds so the big bonds become due periodically going forward instead of them all becoming due at one time so that you can then take the money and invest it elsewhere or invest in bonds that now have possibly a higher return after they have become due. You can do a similar thing possibly with like CDs that you're putting money into a certain time frame you might stagger the CDs so they become due at different time frame so you can then take advantage of the rates if the rates go up during that time. Obviously if the rates go down then having the fixed amount of return could be good in that case so investors can also avoid fees related to funds by holding individual bonds so however possibility of default makes individual bonds too risky in the high yield bond market so often times when you're doing individual bonds if you're in the high yield if you're doing like junk bonds most normal investors probably aren't going to be doing that so much because they might be trying to possibly get some exposure there using other tools such as mutual funds or ETFs so higher volatility so historically high yield bond prices have been much more volatile than their investment grade counter parts which kind of makes sense because you would think there'd be more volatility given the risk factors involved in 2008 high yield bonds as an asset class lost 26.17% of their value in just one year between 1980 and 2020 a diversified portfolio of investment grade bonds including both corporate and government bonds never lost more than 3% in a single calendar year and often times when you're thinking about bonds in your overall portfolio for an individual investor that's often what you're looking for and you're almost looking for often times that boring thing where the increase is not as there as much as equities for example but if the stock market goes down you may not be hit as hard whereas you would think that the up and coming companies the companies that are growing if there's a recession they're going to have less cash flow that's why they're issuing the bonds and so on they're probably more likely to default causing problems around the board whether you're owning stocks there or bonds if the company defaults that could be a problem either way so on the whole the volatility of high yield bonds is closer to the stock market than investment grade bond market