High yield bonds

High yield bonds, also called junk bonds, are bonds (corporate, municipal, or foreign) with low credit quality. These companies are at much greater risk of default than higher quality credits and, as a result, pay higher coupon interest rates than comparable high quality corporate bonds.

Definition
High-yield bonds are generally defined as bonds rated below BBB. Historically, most high-yield bonds were originally investment-grade bonds which were downgraded to junk status. The 1980's saw the widespread use of mezzanine financing in leveraged buy-outs and a dramatic expansion of the size of the junk market from $2.6B in 1977 to $227.8B in 1989 (Handbook of Fixed Income Securities, 1991).

Risks
High yield bonds inherit risks applicable to bonds, some of which are pronounced in high yield bonds.

Credit risk
Since high yield bonds are issued by companies with low credit ratings, there is a much greater risk that the issuers will default.

Call risk
Issuers call their bonds when the interest rate goes down. High yield bonds come with additional call risk. If the issuers' credit ratings improve, they can call the existing bonds and borrow money at a lower interest rate. This type of call risk is not applicable to bonds with high ratings. Bonds which do not change credit ratings are still subject to call risk from interest rate changes.

Role in a portfolio
High-yield bonds should almost always be purchased as part of a fund, since their high default risk makes diversification essential, and their high trading costs make individual purchases unwise.

Due to relatively poor investment vehicles and the high risk of this asset class, investors could very easily choose not to include it at all in their portfolios. Certain commentators even argue that the risks are unlikely to be rewarded in the future, and that past success was more due to statutory changes limiting the market for junk bonds or due to different kinds of bonds ("fallen angels") that no longer dominate the market (since the rise of bonds used for mezzanine financing) than due to inherent long-term superiority of the asset class. The same commentators generally argue that risk should be taken in equity rather than in fixed income, since the former offers unlimited potential gains, whereas the latter only offers a limited upside due to the coupon being fixed and call options.

Should investors choose to include junk bonds for their diversification and potential high returns, Rick Ferri's All About Asset Allocation suggests 20% of fixed income or 10% of the overall portfolio for early-accumulators, midlife-accumulators, and pre- and active retirees.

When considering the stock/bond breakdown for rules-of-thumb such as "your age in bonds," caution would recommend considering the high-yield portion as part of the former, risky, category rather than as part of the latter, safe, one.

Are junk bonds equity or fixed-income?
While high-yield bonds are a distinct asset class, with their own risk and reward characteristics, they have a higher correlation with equities than do investment-grade bonds. For an investment-grade bond, the growth prospects and future profitability of a company are somewhat irrelevant as long as they are judged to be sufficient to meet future bond obligations. For a high-yield bond (or for a stock), the value of the security is intimately linked to the exact state of future profitability. Therefore, junk bonds are much more sensitive to the particulars of the market's valuation of future financial prospects.

"The high-return characteristics and generally junior position in the capital structure makes this security class much closer to equity than traditional fixed income securities," according to Robert Long in the Handbook of Fixed Income Securities, 1991. He continues, "Financing techniques of recent years have developed a variety of instruments including bonds with equity interests, variable payments depending on operating results or commodity indexes, extendable maturities, resettable coupons, automatic conversion to equity, and other esoteric features that further blur the traditional distinction between bonds and stocks."

At the same time, high yield bonds have as a category had returns which cannot be replicated by simply averaging corporate bonds and equity results, and therefore cannot merely be a hybrid of the two categories. Rick Ferri points out the 1st Quarter 2009 Vanguard Results: +4.6% = High Yield bonds (VWEHX) +0.1% = Intermediate-Treasury (VFITX) -10.7% = US Total Stock Market (VTSMX) -18.1% = US Small Value (VISVX)

In All About Asset Allocation, Ferri states that, "Statistically, only about 25 percent of the default risk in high-yield corporate bonds can be attributed to the same factors affecting equity returns; however the results are not statistically significant. If you allocate 10 percent of your total portfolio to one of the B-BB rated bond funds listed at the end of the chapter, at most perhaps 2 percent of that could be considered equity related. ... That being said, very-low-quality bond funds (those with an average credit quality of CCC or less) do have a higher correlation with equity returns."

Funds

 * Vanguard High-Yield Corporate Fund This fund invests in somewhat higher quality bonds than do most high-yield funds.
 * iShares iBoxx $ High Yield Corporate Bd (HYG)
 * SPDR Lehman High Yield Bond (JNK)

Papers

 * Credit Risk: How Much? When? by William Bernstein
 * Is Default Event Risk Priced in Corporate Bonds? by Joost Driessen of the University of Amsterdam (March 2002)
 * The Investment Performance and Market Size of Defaulted Bonds and Bank Loans: 2006 Review and 2007 Outlook by Altman, Edward I. and Swanson, Jeffrey
 * Determinants of Recovery Rates on Defaulted Bonds and Loans for North American Corporate Issuers: 1983-2003 by Cantor, Richard Martin and Varma, Praveen, Journal of Fixed Income, December 2004