Non-Investment Grade/High Yield Bonds
Product Overview
Non-investment grade or high yield are terms applied to bonds rated below Baa3 on the Moody's® credit rating scale and below BBB- on the equivalent ratings systems from S&P® and Fitch. The credit ratings are assigned based upon the issuer's ability to pay interest and principal. Credit ratings below Baa3 on the Moody's® credit rating scale and below BBB- on the equivalent ratings systems from S&P® and Fitch denote that the company's financial position is weak and its bonds should be considered as a speculative investment.
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Features of Non-Investment Grade/High Yield Bonds
In the context of corporate bonds, high yield corporate bonds share many of the same features as investment grade corporate bonds. At the same time, the issuers are more likely to be confined to U.S. corporations, without the foreign corporate or sovereign issuers that are present in the investment grade corporate market. They are also issued with shorter maturities and are more likely to be callable so that if a company's financial condition improves it can take advantage of lower funding rates.
The high yield market has grown in recent years and in addition to being populated by former investment grade companies that are in decline, the high yield market also provides financing for emerging companies seeking working capital for expansion or to fund acquisitions.
Benefits of Non-Investment Grade/High Yield Bonds
High Yield Bonds hold the potential for higher returns stemming from several sources:
- Higher Coupon Rate: This can produce higher levels of income from a given investment amount.
- Capital appreciation: Some investors in high yield bonds seek out potential turnaround stories in the hope of capturing the gain in value as investors' and the ratings agencies' opinions change from pessimistic to not quite so pessimistic.
Risks of Non-Investment Grade/High Yield Bonds
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.
- Default risk: Defaults occur when a company fails to make an interest or principal payment to a debt holder as scheduled and as specified in the legal agreements. The risk of default on principal or interest, or both, is greater for high-yield bonds than for investment-grade bonds.
- Default risk extremes: Default risks vary across the high yield segment. A study from Moody's showed how Corporate bonds rated Ba, just inside the high yield category, had a 1.1% probability of defaulting within a year; whereas more speculative bonds, rated Caa-C, had a one-year default probability of over 16%*. Investment grade bonds had under 0.5% probability of a default within a year.*
- Call risk: Many corporate bonds are callable and have a predetermined call schedule. Callable bonds can be redeemed or paid off at the issuer's discretion prior to the bonds' maturity date. Typically an issuing corporation will call its bonds when interest rates fall, leaving the investor with less favorable reinvestment possibilities. Investors may suffer capital loss and lower yields as a result of their bond being called by the issuer. When evaluating high yield corporate bonds, an investor should know whether call options exist and when they may be exercised. The offerings table on Fidelity.com displays an attribute of CP for those offerings which are call protected. The Securities Detail for those bonds not call protected shows a link to a complete call schedule.
Make-whole calls
Some new issues have the option to call the bond as interest rates decline. Issuers may call these bonds at par plus a premium. This feature is referred to as a make-whole call. The amount of the premium is derived from the yield of a comparable Treasury security plus additional basis points. Because the cost to the issuer can often be significant, make whole calls are not frequently invoked. - Credit risk: Corporate bonds are subject to credit risk; however these risks can be reduced by investing in higher rated securities and/or by building a diversified portfolio. Bonds with lower credit ratings are more likely to be in danger of default. If a bond issuer fails to make either a coupon or principal payment on its bonds as they come due, or fails to meet some other provision of the bond indenture, it is said to be in default.
- Event risk: A corporate bond's payments are dependent on the company's ability to finance its debt. Unforeseen events could impact the issuer's ability to meet their financial commitments.
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Business cycle risk: Because high yield issuers typically have riskier business strategies and balance sheets reflecting greater leverage, they are at greater risk from a general downturn in business conditions.
Source Moody's
- Concentration risk: Because of the higher level of issuer-specific risk associated with a concentrated position in non-investment grade bonds, investors should seek diversification across a wide range of names and industries in order to reduce the negative impact of a default on their portfolios.
- Equity correlation risk: The yields of non-investment grade bonds may be high because of the high degree of uncertainty in the company's ability to generate sufficient cash-flow from operations. This is very similar to one of the primary concerns of equity holders. Thus investors in high yield bonds may find that their bonds fall along with an economic or stock market downturn.
- Liquidity risk: High yield bonds that may have been fairly liquid or easy to buy and sell when market conditions were calm can suddenly become very difficult to sell when volatility increases. Typically, high yield bonds suffer greater illiquidity in these circumstances than investment grade or government bonds.
- Research and monitoring demands: Current and accurate information can be more difficult to obtain than for investment grade bonds. Investors in high yield bonds need to do their homework as they consider what to invest in as well as monitoring the changing financial condition of the company over time.
Investing in High Yield Bonds at Fidelity
Investors may search and purchase non-investment grade bonds at Fidelity.com where you can choose the credit ratings levels appropriate for your portfolio and your risk tolerance. You can also research recent ratings actions before you buy and evaluate the liquidity risk based upon real-time TRACE (Trade Reporting and Compliance Engine) data.
Once you have made your purchase, we encourage you to sign up for Fidelity's Fixed Income Alerts to receive real-time email notifications in the event that one of your bond holdings is downgraded or placed on negative credit watch.
Top* "Average One-Year Corporate Whole Letter Rating Migration Rates, 1970 - 2008"; Moody's Investors Service
Call a fixed income specialist for assistance: 800-544-5372.
