“In investing, what is comfortable is rarely profitable.” – Robert Arnott
Bonds are an important component of many investors’ portfolios. In the past, they offered a stable return compared to other investments such as stocks, which are more volatile. There are many types of bonds, but most of them typically fall into one of two categories: investment grade or high yield. In this article, we’ll be looking at investment grade and high yield bonds and how they offer returns on bonds.
The main difference between the two bond categories lies in their credit rating and how investors view each category’s risk in each.
Investment Grade Bonds
An investment grade bond is a bond that has a credit rating of BBB or higher, according to the Standard & Poor credit rating system. These are bonds that investors and rating agencies believe are likely to pay back their debt. If a bond as a AAA rating, then agencies have given it the highest quality rating. This means that those agencies believe that the company will pay back all of its debt, with interest, on a fixed, consistent schedule.
Investors regard US government bonds as the highest quality bonds out there because they are backed by the full faith and credit of the US government. But, in August 2011, as the US government’s budget deficit, or difference between the government’s spending and revenue from taxes, was getting bigger. The US had to spend to stimulate the economy following the Financial Crisis of 2008, but because they weren’t making enough revenue in taxes, they couldn’t pay back the deficit and debt began to accumulate. Standard & Poor consequently knocked down the credit rating for the US government from AAA to AA+ in the face of growing debt. In 2008, 10-year US Treasury Bonds yielded 4%. As of May 2020, due to the Fed’s expansionary monetary policy after the Financial Crisis as well as the recent response to the coronavirus, 10-year US Treasuries yield about 0.65%.
As of February 2020, there are only two companies with the highest credit rating of AAA — Microsoft and Johnson & Johnson. This means that rating agencies and investors believe that Microsoft and Johnson & Johnson are better at paying their debts than the US government!
Since investment grade bonds are likely to be paid back, there is little risk of losing money with them. Investors are willing to accept a lower return on such bonds because they know that the bonds are likely to be paid back. In other words, because the risk of the bond defaulting is low, investors are willing to accept a lower return on the bond, which manifests as a lower yield on the bond compared to their riskier counterparts, high yield bonds.
High Yield Bonds
High yield bonds are bonds rated below BBB-. Investors regard them as low quality. Often nicknamed “junk bonds”, their credit rating indicates that they are more likely to fail to pay their debt obligations. In other words, a lower credit rating indicates a higher likelihood of a negative credit event, such as a default or bankruptcy.
Since high yield, “junk” bonds have a higher risk of default, there is a bigger risk of losing money with them. Investors, therefore, demand a higher return on such bonds because they know that the bonds may fail to be paid back. But, investors make a nice return in the event the bond pays back, which is the initial reason they buy high yield bonds. In other words, because the risk of the bond defaulting is higher, investors want a higher potential return on the bond, which manifests as a higher yield on the bond. For this reason, these bonds are termed “high yield bonds”.
Let’s take a look at an example of a high yield bond. Gamestop’s 2021 bonds have a Moody’s credit rating of Caa2 and yield 6.75%. The rating indicates that the bond is not safe and has a high risk of default. Consequently, GameStop issued those bonds with a yield higher than many other bonds that had better credit ratings in order to incentivize investors to take a big risk and buy them.
Investors have integrated these high yield bonds into their portfolios throughout the years. However, many investors indirectly own these high yield bonds through mutual funds or ETFs. Similar to stocks, high yield bonds offer a great reward but with great risk. Many mutual funds and ETFs offer investors the ability to invest in bonds. There are several great funds that specialize in high yield bonds such as the Vanguard High Yield Corporate Fund Investor Shares (VWEHX) and SPDR Barclays Capital High Yield Bond ETF (JNK).
The bond market is a big market with many opportunities to make money. In fact, the US bond market is bigger than the US stock market, by about $10 trillion dollars. In this market, most bonds are either investment grade or high yield. Bondholders must evaluate the risks of the bonds they buy and decide whether to invest. While some investors chase after high yield bonds to grow their money, the important thing to remember is to gauge your risk tolerance and understanding of the bond market. Every investor has a different situation and should make the choices that best fit their situation. Incorporating both high yield and investment grade bonds into a portfolio may be a strategy worth exploring.