Investment Grade vs High-Yield Bonds

High yield bonds, often called junk bonds, are corporate bonds rated below investment grade: BB plus or lower by S&P and Fitch, Ba1 or lower by Moody's. Issuers include smaller companies, highly leveraged firms, companies owned by private equity and former blue chips that have been downgraded. In exchange for higher default risk, these bonds pay higher yields. High yield bonds behave partly like bonds and partly like stocks, and their performance is closely tied to the economic cycle.

Who issues high yield bonds#

The market grew in the 1980s, led by Michael Milken at Drexel Burnham Lambert, who popularised high yield bonds for financing growth companies and takeovers.

Yield and spread#

High yield bonds typically trade at spreads of roughly 3 to 6 percentage points over Treasuries in normal markets, widening to 10 points or more in recessions. In late 2008, the average US high yield spread exceeded 19 percentage points; in March 2020 it briefly topped 10. See Credit Spreads.

Defaults and recoveries#

expected loss ≈ default probability × (1 - recovery rate)

Long term data from Moody's shows average annual default rates for speculative grade issuers of roughly 4%, with peaks above 10% in recessions such as 1991, 2001 to 2002 and 2009.

How high yield bonds behave#

High yield bonds have historically shown meaningful correlation with equities, so they provide less diversification than government bonds during market stress. See Diversification.

Features of high yield bonds#

• Shorter maturities: often 5 to 10 years.
• Call provisions: commonly callable after a few years at a premium.
• Covenants: more restrictive than investment grade, though "covenant lite" structures have grown.
• Lower liquidity, especially for smaller issues.

Investing in high yield#

• Funds and ETFs provide diversification across hundreds of issuers, which matters because individual defaults can cause large losses.
• Active managers focus on credit analysis to avoid defaults.
• Distressed investors buy bonds trading far below par, betting on recovery. See Distressed Debt and Bankruptcy Trading.

Risks#

• Default risk and loss of principal.
• Spread widening in downturns, causing price falls even without defaults.
• Liquidity risk: prices can gap in stress, and ETFs can trade below the value of their holdings.
• Call risk: good performers get called away.
• Concentration in sectors such as energy, where commodity crashes have caused waves of defaults (2015 to 2016, 2020).

Frequently asked questions#

What are high yield bonds?#

Corporate bonds rated below investment grade, which pay higher yields to compensate for higher default risk.

Why are they called junk bonds?#

Because of their lower credit ratings. The term reflects higher risk, not necessarily poor quality businesses.

How do high yield bonds perform in recessions?#

Spreads usually widen and default rates rise, causing price declines that can be similar to stocks.

Next, learn how bond credit quality is graded in Credit Ratings.