Understanding High-Yield Bonds

High-yield bonds, often referred to as “junk” or “speculative grade,” are corporate bonds that command a higher interest rate than other bonds. This higher yield is essentially compensation for the increased risk of default that investors assume when purchasing these securities. Credit rating agencies including Moody’s, Fitch, and Standard & Poors determine whether a bond is high-yield or investment grade.

Role of Agencies

Credit rating agencies (CRAs) have specific rating tiers. Investment-grade bonds are those with a higher credit quality, indicating a lower risk of default. These have ratings from BBB (or its equivalent) and above. The lowest threshold that would still qualify a bond as investment grade would be BBB- from S&P and Fitch, and Baa3 from Moody’s. High-yield bonds occupy the lower half of the ratings, all the way from BB+ for the most creditworthy high-yield bonds, down to C for the least (using the S&P and Fitch scale).

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Ratings are not static. If a company’s financial condition changes or if macroeconomic factors shift, CRAs can upgrade or downgrade ratings. For instance, a bond can transition from investment grade to high-yield (becoming a “fallen angel”) due to a rating downgrade. The high-yield universe comprises both companies rated as non-investment grade when they first issued bonds and those that fell into that rating over time, after their bonds were on the market.

It’s worth noting that while CRAs play a pivotal role in financial markets, they have faced criticism in the past, especially during the 2007-2008 financial crisis. Ratings can be a good starting point for analyzing a bond, but should be used in conjunction with other research and not as the sole determinant in investment decisions.