High-yield bonds
The bond market is one of the largest financial markets in the world with a value of over $100 trillion. It is made up of debt securities that vary in length, duration and yield. High-yield bonds fall into a lower asset class than investment-grade bonds in terms of credit ratings, although they can provide a good opportunity for longer-term returns if successful.
Bond trading in general is seen as a relatively safe investment, especially when trading government bonds or gilts. However, bonds issued by high-yield markets can be risky investments, depending on the total return. Therefore, it may be wise to think about diversifying your trading portfolio with both junk bonds and investment-grade bonds to offset the risk of loss.
In this article, we explore the process of investing in high-yield bonds in the UK, along with the advantages and disadvantages. We also provide spread bets and CFDs on a number of top high-yield bond products, such as bond ETFs and bond indexes, that are available to trade on our online trading platform, Next Generation, whose prices are based on the underlying assets.
What are ‘junk bonds’?
High-yield bonds are also referred to as junk bonds due to their lower status than typical corporate and government bonds. Bonds issued with high yields tend to come from start-up businesses or those that require a lot of investment. They have lower credit ratings and are more likely to default, which is when a bond issuer fails to repay the debt or financial obligation that has been agreed between parties.
Therefore, junk bonds tend to pay higher interest rates to investors in order to compensate for this risk. High-yield bonds can be classified into two categories, depending on their current status:
- Fallen angels: bonds that were previously investment-grade that have been declining consistently in credit value, lowering their status to junk bonds.
- Rising stars: junk bonds that have an increasing credit value and in turn, an increasing bond rating, which will perhaps one day classify as an investment-grade bond.
High-yield bond fund ratings
High-yield bonds are corporate securities that are scaled on a credit rating by notable agencies such as Standard & Poor (S&P) and Moody’s. If a bond has a rating of BBB- from S&P or Baa3 from Moody’s, then it is most likely to have a higher yield.
The lower the rating goes, the more speculative and risky the bond. If the credit rating is a D, this means that the bond is in default and it is struggling to pay its obligated debt. Anything above these ratings is considered investment-grade level.
Are high-yield bonds a good investment?
Junk bonds are often seen as less stable and reliable than their investment-grade equivalents, although they do provide certain benefits. So, why invest in high-yield bonds?
There are both benefits and drawbacks. The most obvious attraction of investing in high-yield bonds is the higher interest rates and subsequent dividend yields in comparison with more investment-grade bonds. This can lead to longer-term returns and a steady income if the bond does not default. We will explore these advantages and disadvantages of junk bonds in more detail throughout the article.
Whereas some traders prefer to invest into individual junk bonds, the risk of default and capital loss is much more prominent. Instead, mutual funds and exchange-traded funds (ETFs) are effective ways of investing into high-yield bonds in order to spread the risk over a number of instruments in an index.*
High-yield bonds to watch
| Name | 1-year return rate | 3-year return rate | 5-year return rate | Dividend yield |
|---|---|---|---|---|
| SPDR Barclays High Yield Bond ETF | 1.79% | 3.62% | 4.82% | 4.88% |
| Credit Suisse High Yield Bond Fund | -7.64% | 0.34% | 9.31% | 9.17% |
| iShares US High Yield Bond Index ETF CAD-Hedged | 0.67% | 2.58% | 4.13% | 5.29% |
| SPDR Barclays Short Term High Yield Bond ETF | 1.58% | 3.31% | 4.53% | 4.69% |
| Market Vectors Emerging High Yield Bond ETF | 6.20% | 3.52% | 6.30% | 5.70% |
How to invest in high-yield bonds
With CMC Markets, it is possible to trade on junk bonds with a spread betting or CFD trading account. These are both derivative products that allow traders to speculate on the price movements of a high-yield bond fund or ETF.
Open a live account to get trading on junk bonds within various sectors, including those mentioned above. It is also possible to practise trading risk-free with virtual funds by opening a demo trading account, in order to feel comfortable with bond trading.
How to short junk bonds
Traders can open either long or short positions, depending on the asset. If you think a particular ETF is due to drop in value, you can sell it at its current higher price in the hope of buying it back for a cheaper price. This is known as short selling in the bond market, which also has a very high risk/reward ratio. As high-yield bonds are affected by interest rate fluctuations, traders should pay close attention to price charts. When interest rates increase, bond prices tend to fall; this would be an opportune moment to make a short sale while the price is still at a higher level. You can then buy back the ETF at a lower price.
Junk bonds: advantages and disadvantages
As mentioned, there are both advantages and disadvantages when investing in high-yield bonds. The advantages are as follows:
- They have a high risk/reward ratio. This means that if you are prepared to risk losing capital, then it may pay off in the long-term through a higher rate of return or income.
- Bonds are less volatile than stocks in terms of company earnings and other external factors, and as long as they do not default, there should be a steady income.
- Some traders hope that the value of the junk bond will increase over time, along with its credit rating. If there is high potential for a company to appreciate in value, this may be a good time to take a risk.
Nevertheless, junk bonds are a relatively risky investment, especially when trading with leverage. The disadvantages are as follows:
- There is a much higher chance of default. This means that you could lose your entire capital from one investment, which scares investors away.
- High-yield bond prices are affected by factors such as interest rates and credit ratings. If credit ratings fall, the price and value will fall with it. On the other hand, if interest rates rise, the bond’s value will decrease, which is typical during a recession. Therefore, junk bonds are the opposite of safe haven assets, such as gold and government bonds.
- The liquidity of the junk bond market is not as high as for other bonds. Due to being high-risk assets, they are difficult to re-sell and therefore, the market can be stagnant at times.
Summary: are high-yield bonds worth the risk?
Overall, investing in high-yield bonds proposes the risk of losses on a large scale, which is why some traders favour more secure and stable securities, such as government bonds. However, the risk/reward ratio for junk bonds is greater, therefore, it depends on how much you are willing to lose in exchange for possibly larger profits in the long-term. This is something to consider when building your trading strategy, and you should also take advantage of our risk management tools when opening positions, such as stop-losses and other execution types.
Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.