A high yield bond is a debt security issued by a corporation, government entity, or other financial organization rated below investment grade by a credit rating agency. A high yield bond is therefore deemed to be comparatively risky in terms of the likelihood that investors will receive timely payments of interest and principal. As a class, high yield bonds also have higher default rates than investment grade bonds. Hence, investors typically require that high yield bonds pay greater rates of coupon interest. High yield bonds are also known as speculative grade or junk bonds.
As is true for all bonds, high yield bond investors take on the risk that market interest rates, economic conditions, and credit quality of the issuer may change over the life of the bond. Such changes may adversely affect the value of the bond and the issuer's ability to repay interest and principal as per the terms of the bond's indenture agreement. As they carry a comparatively high coupon rate of interest, high yield bonds generally include a "call" provision. This allows the issuer to buy back the bonds from investors at preset prices after a certain date.
High yield bonds are generally more volatile than higher rated, less risky bonds. Carrying a higher rate of coupon interest, the price of a high yield bond will change more than that of a bond with a lower coupon for a given adjustment in interest rates, all other aspects of the two bonds being equal. In addition, the risk of an adverse credit event, such as a default, by the issuer of a high yield bond is greater than that of investment grade debt securities.
Credit ratings agencies routinely rate bond issuers and specific bond issues in order to streamline and make the process of raising capital through the issuance of debt securities, such as high yield bonds, more efficient. Standard & Poor's, Moody's, and Fitch Ratings are the three principal ratings agencies in the U.S., and each uses its own grading system to indicate a bond's credit quality. Corporations and other organizations that issue high yield bonds do so through investment banks, which "underwrite" the securities. This means that they buy them from the issuer and sell them to investors, typically over the course of one to several days. The investment banks pay the credit ratings agencies to rate the bonds prior to issuance. Hence, something of a conflict of interest may exist in the relationship between them; this is an issue that high yield bond investors should be aware of.
