How to Invest in Bonds and Loan Notes

Characterised by their lower credit ratings compared to investment-grade bonds, high-yield bonds inherently carry an increased risk of default. However, this risk is offset by the potential for higher returns, making them an attractive option for investors seeking to balance risk and reward.

Understanding High-Yield Bonds

High-yield bonds represent debt instruments issued by corporations committed to paying interest and repaying the principal upon maturity. These bonds are typically issued by companies with weaker credit profiles, reflecting a higher risk of default compared to their investment-grade counterparts.

The classification of bonds into investment-grade and non-investment-grade categories is based on their credit quality. Non-investment-grade bonds, including high-yield bonds, bear lower credit ratings assigned by major credit rating agencies.

A bond is deemed non-investment grade if it falls below specific rating thresholds established by agencies like Standard & Poor’s, Fitch, and Moody’s. Ratings below BB+ from Standard & Poor’s and Fitch, or Ba1 or lower from Moody’s, categorise bonds as non-investment grade. Bonds rated at or above these levels are considered investment grade.

Within the realm of high-yield bonds, two subcategories emerge:

• Fallen angels: Bonds downgraded by rating agencies, signaling a deterioration in the issuing company’s credit quality and potentially transitioning towards bond status.
  
  
• Rising stars: Bonds experiencing upgrades in credit ratings due to improvements in the issuing company’s financial health, though they may still reside within the high-yield bond category.

Advantages and Disadvantages of High-Yield Bonds

Investors are drawn to high-yield bonds primarily for their potential for enhanced returns. These bonds typically offer higher yields compared to their investment-grade counterparts, provided they do not default.

However, it’s essential to acknowledge the accompanying risks:

Advantages:

Greater potential for returns, aligning with the principles of modern portfolio theory where higher risks correspond to higher expected returns.

Disadvantages:

• Default risk: The heightened likelihood of the issuer failing to meet its debt obligations.
• Volatility: High-yield bonds historically exhibit greater price volatility than investment-grade bonds, akin to fluctuations observed in the stock market.
• Interest rate risk: All bonds are susceptible to changes in market interest rates, potentially leading to declines in bond prices.
• Liquidity risk: High-yield bonds often face challenges in liquidity compared to investment-grade bonds, impacting their tradability and pricing accuracy.

Understanding these risks is crucial for investors considering high-yield bonds as part of their portfolio diversification strategy.