In a yield-starved environment, investors are looking for bonds that pay more, and high-yield bonds, also called “junk” bonds, may be quite appealing to some.
Many years ago, a group of credit rating agencies (Moody’s Investor Service, Standard & Poor’s, and Fitch Ratings) developed a system to “grade” the relative credit quality of bond issuers. The highest-quality bonds are rated AAA, and the credit scale descends to D (for default).
Subsequently, many financial institutions restricted their investments to the highest-rated bonds, called investment-grade bonds. Lower-rated bonds, meanwhile, developed a negative connotation and soon became known as junk bonds.
But junk bonds aren’t necessarily junk. Over time, many investors have discovered that the risk-adjusted returns for junk bonds were high, and they began to buy them. Indeed, junk bonds tend to be particularly appealing when yields on other bonds are low, as they are today, when the U.S. Federal Reserve Board is opting to keep interest rates low. In fact, it may be more accurate to call them high-yield bonds instead of junk bonds.
Of course, while high-yield bonds may pay higher yields than investment-grade bonds, they may also have higher volatility and higher risk of default. While no investment is ever totally safe, portfolio managers try to minimize these risks by using credit analysis to evaluate the possibility of a bond issuer’s default. And they diversify their portfolios, which can help balance the ups and downs of individual bond prices; some might perform poorly, while others might be performing well.