A high yield bond is a financial term used to describe a bond that is rated below the investment grade. Therefore, high yield bonds are also known as non-investment grade bonds or junk bonds. These bonds have a higher risk of defaulting, but typically pay high yields in order to make them attractive to investors.
If you have a high yield bond you are subject to interest rate risk and credit risk. Interest rate risk refers is the risk of a bond changing in value due to changes in the structure or level of interest rates. The credit risk of a high yield bond refers to the probability of a default (for example a debtor unable to meet interest and principal obligations) combined with the probability of not receiving principal and interest in arrears after a default.
High yield bond investments depend hugely on credit analysis. Credit analysis is like equity, because it is based on issuer fundamentals, and a “bottom-up” process. Credit analysis of high yield bonds are concentrated on the “downside” risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group, and issue type. Due to the high minimum size of bond trades and the specialist credit knowledge required, most individual investors are best advised to invest through high yield mutual funds.
High yield bonds are one (but not the only) factor that accounts for the sudden collapse of several high profile companies such as Enron and WorldCom, whose bonds were not initially rated as high yield. Investors in high yield bonds hope that credit quality will improve over time, and when the perceived risk of a credit decreases, then the return (interest rate) demanded by investors will also decrease, and the price of the bond will increase. This is the method that investors in high yield bonds use.
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