High-yield bonds pay more, but there’s a catch: Who should invest and how much risk can you take?

High-yield bonds can offer investors higher interest income than highly rated debt securities, but the higher yield comes with greater credit risk. These bonds are issued by companies with lower credit quality, which means investors face a higher risk of credit deterioration and, in some cases, default.

Globally, bonds rated below BBB are generally considered high-yield bonds. In India, investors can also come across relatively higher-yielding opportunities in the AA and A+ segments, without necessarily taking on the level of risk associated with bonds rated below BBB, according to Souvik Biswas, head of research at Bajaj Capital.

Rhishabh Garg, CEO of FundsIndia Digital, said bonds rated BBB and above are considered investment grade in India, while BB and below fall into the high-yield category.

Why do high-yield bonds offer higher interest?

The higher interest offered by these bonds is linked to the credit risk of the issuer. Investors are generally compensated with a higher yield when the perceived risk of repayment is higher.

“Since there is a higher perceived risk of repayment, investors are generally compensated through a higher yield compared with bonds that have stronger credit ratings,” Biswas said.

Garg noted that the higher coupon should not be viewed separately from the risk being taken. A weaker credit rating indicates a higher level of repayment risk, which is reflected in the yield offered by the bond.

This makes the credit rating and the financial position of the issuing company important factors when assessing a high-yield bond.

High yield comes with multiple risks

Default is one of the key risks associated with high-yield bonds. However, investors also need to consider credit-rating downgrades, liquidity risk, interest-rate risk and concentration risk.

These risks can also be interconnected. A deterioration in an issuer's financial position can lead to a rating downgrade. That can put pressure on the bond's market price and make it more difficult to sell. If the issuer's financial position continues to weaken, the risk could eventually extend to default.

A rating downgrade can affect an investor even when the company continues to make its interest payments.

A downgrade signals that the rating agency sees a higher level of credit risk. Investors may then demand a higher yield for holding the bond, which can result in a fall in its market price, Biswas explained.

The market can therefore reprice a bond following a downgrade because the new rating indicates higher credit risk. Since the coupon on an existing bond is fixed, its market price can fall to bring its yield in line with the return investors now demand, Garg said.

Selling before maturity carries another risk

This distinction becomes important for investors who may need to sell the bond before maturity.

If the issuer continues to meet its obligations, a downgrade alone does not change the contractual coupon or principal repayment. However, the bond's market price can decline.

Liquidity can add to the difficulty of exiting. Many high-yield bonds trade thinly in the secondary market, Garg noted. If the issuer's credit position deteriorates, selling the bond before maturity can therefore become more difficult and may require accepting a lower price.

The remaining maturity is another factor investors can consider. A higher-yielding bond with 12–18 months remaining to maturity may have a shorter period of exposure to changes in the issuer's credit profile. However, credit and liquidity risks remain, Biswas said.

Investors should also understand the underlying business of the issuer. For instance, the nature of the assets backing a lender's business and its lending practices can be relevant when assessing credit risk.

A secured lending model may provide an additional layer of collateral protection compared with an unsecured lending model, although it does not eliminate credit risk, he added.

Who should consider high-yield bonds?

High-yield bonds can be a source of potentially higher regular income for investors who understand the risks and are able to hold the security through maturity.

However, true high-yield bonds, or those rated BBB and below, require a strong understanding of the issuer and its business, along with a higher tolerance for risk, Biswas said. Such bonds are generally not suited to conservative investors.

The risk-return characteristics of these bonds can also be more closely linked to broader economic conditions and the financial health of the issuer than those of highly rated bonds, such as government or government-related securities.

For investors who already have a significant allocation to equities, adding higher-credit-risk debt may therefore not provide the same diversification benefits as high-quality fixed income, Biswas noted.

Garg said high-yield bonds may suit investors who have already built the stable part of their fixed-income allocation and are knowingly adding a smaller allocation for additional return.

How much should investors allocate?

There is no one-size-fits-all allocation to high-yield bonds.

The appropriate exposure depends on factors such as the investor's risk appetite, income requirements, investment horizon, liquidity needs and existing portfolio composition.

A well-researched portfolio may consider higher-yielding bonds in the AA to A+ segment as part of its fixed-income allocation, depending on the investor's overall objectives and risk profile, Biswas said.

Bonds rated BBB and below should be approached with considerably greater caution because of their higher credit risk and the potential for loss of capital in the event of default.

Garg added that high-yield exposure should generally be a smaller, satellite allocation within the overall debt portfolio rather than a substitute for the core fixed-income allocation. It should also be sized so that a default or significant loss in one investment does not materially affect the portfolio.

For investors considering these bonds, the key factors highlighted by the experts are the issuer's credit quality, the underlying business, the bond's maturity, liquidity and the investor's own risk appetite and income requirements.