High Yield Bonds: Navigating Risks And Opportunities

In the post-pandemic world, inflation has been a major cause of concern. According to IMF research, global inflation surged to 7.5 percent in August 2022, from an average of 2.1 percent in the decade preceding the COVID-19 pandemic. Investors worldwide have been seeking investment classes that can help them beat this surging inflation. With global interest rates on the rise, one interesting asset class that provides them a powerful alternative is the high-yield bonds space.

Credit Ratings In The Fixed Income Space

Before understanding what high-yield bonds are, we need to first evaluate the relationship between different kinds of assets in the fixed-income space, and how they differ from each other. These assets are classified based on their credit ratings, i.e., the higher the credit rating, the better the investment grade of the asset. Fixed deposits of renowned banks like HDFC and SBI fall under the CRISIL AAA category, and those of NBFCs like IIFL Finance are CRISIL AA rated. As these ratings vary, so does the interest rate offered by these entities. A 3-year HDFC fixed deposit might provide an interest of 7.2% per annum, while an IIFL bond of the same tenor would be offered at around 9% per annum. An 'A' rated or higher rated bond being offered on the Grip platform currently, fetches up to 11% yield.

Credit ratings for long-term bonds generally follow this kind of flow, in the order of decreasing credit rating:

AAA

AA

A

BBB

BB

B

C

D

Further, every issuance of a bond by an entity has a specific credit rating assigned to it, which not only depends on the entity issuing the bond but also on the kind of collateral offered by the entity. Hence, an unsecured bond of the same entity would be lower rated as compared to a secured one.

What Are High Yield Bonds?

High-yield bonds can simply be classified as fixed-income instruments which fall under the credit rating category of BBB and below. These bonds are issued by corporates to the general public, and the proceeds from these issuances are utilized to either fulfill their working capital requirements or for some kind of expansion.  These bonds offer a high rate of interest, which makes up for the risk associated with the bonds.

Based on the financial health of the entity issuing high-yield bonds, these bonds can be further divided into the following two categories:

-Fallen Angels: Bonds that have been downgraded by the rating agencies due to the deteriorating performance of the issuing entity, and have fallen from investment grade to the  high-yield category

-Rising stars: Bonds that are being upgraded by credit rating agencies. The progression happens as the issuing entity shows significant improvement in its business. Such bonds can even be promoted to the investment grade category over time

 More About The Classification

Let us suppose a company ANN, which is in the business of manufacturing and is BBB rated, comes out with a bond issuance at a 15% per annum rate of interest. At the same time another company BNN, which is in the same business but is AA rated, raises funds at 9% per annum. Now both these bond issuances have a tenor of 3 years.

Two years after the issuance, ANN declares that it has developed a sophisticated technology that can make them market leaders globally. Analysts start spotting improvement in their financials, and a year later, upgrade their credit ratings from BBB to A status. Thus, ANN is a rising star in this case.

On the other hand, BNN’s market share begins to drop significantly, and so does its financials. BNN is eventually downgraded to the BBB credit rating status, making them a fallen angel.

Benefits Of High Yield Bonds

Several benefits of junk bonds make them a lucrative instrument for investments: 

-Enhanced income:  These bonds offer a high rate of interest, thereby giving a boost to the investors’ income

-Diversification: For an investor, high-yield bonds provide an opportunity to diversify their investment portfolio.

-Equity-like returns, with lower volatility: These bonds have the potential to generate returns in the range of 13-18%, which is in line with equity index and mutual fund returns. Moreover, these returns are fixed, so volatility is less. Moreover, bondholders of a company are given preference over shareholders in case of liquidation, which is another advantage that they have over equity investments

-Capital appreciation: For investors who can catch rising stars and invest in their bonds, the returns can even go higher, as their bond prices will move up, thereby leading to capital appreciation for the investors

 Risks Associated With High Yield Bonds

While these bonds and their returns might sound too good to be true, there are several risks associated with them –

-Default risk: Since the companies offering these bonds are BBB and below rated, they carry the risk of defaulting on these commitments. One should always hunt for companies that have a high level of corporate governance and provide full disclosures

-Liquidity risk: Unlike corporate bonds, high-yield bonds are generally not traded in the secondary market. It is quite a difficult task for an investor looking to liquidate them before maturity

-Credit rating risk:  These bonds also carry the risk of being downgraded in case the company faces some kind of business or financial challenges, thereby bringing down the price of the bond. However, this risk is not a cause for concern as long as the investor plans to hold the bond till maturity and the company can pay back its dues on time

-Interest rate risk:  As interest rates rise, bond prices fall. This effect of rates on bond prices is more profound when bonds have high tenors. High-yield bonds generally have tenors in the range of 1-5 years, thus interest rate risk is not a big factor to consider while investing in these bonds

Conclusion

High yield bonds, albeit risky, can be a source to generate alpha returns in a diversified portfolio. For an investor, it is necessary to keep asset allocation in mind while investing in such products. They might be a close substitute to equity returns, but - just like equity investments, an investor must thoroughly understand the business that they are investing in, before parking their hard-earned money.

We, at Grip, give you a destination to explore both investment grade bonds and other high-yield fixed-income options giving inflation-beating returns up to 16% IRR. 

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Disclaimer: This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip Invest Technologies Private Limited ("Grip", formerly known as Grip Invest Advisors Private Limited) is not registered with SEBI in any capacity and does not advise, encourage, or discourage its users to invest or not invest in any securities. Grip is solely an execution-only platform and does not guarantee or assure any return on investments made by you in any opportunities sourced by Grip and accepts no liability for consequences of any actions taken based on the information provided. Your investment is solely based on your judgement. Investments in debt securities are subject to risks. Read all the offer-related documents carefully.