High Yield Bonds: top picks for investors

What are high yield bonds and how do they work?

High yield bonds work in exactly the same way as regular bonds. They are issued by organisations – usually companies and some governments – wanting to raise capital. Investors lend them money by buying these bonds. In return, they receive a set amount of interest, known as a coupon, and the bond’s face value on a future date.

As these names imply, high yield bonds offer better interest rates because they are riskier than investment grade corporate bonds and most government bonds. This means there’s a greater chance of them defaulting on their obligations, which is why they are sometimes referred to as ‘junk bonds’, ‘sub-investment grade ‘or ‘speculative grade’.

Companies issuing high yield bonds may be relatively new, operate in volatile areas, have weaker balance sheets or carry high debt levels. Similarly, countries in the high yield space may be characterised by political instability, weaker public finances, high debt levels, and a history of currency risk.

Bonds are rated by credit rating agencies such as Moody’s and Standard & Poor’s (S&P). These ratings are designed to show how likely the bond issuer is to keep making interest payments and repay the original amount invested. While the agencies use slightly different rating labels, they are broadly trying to measure the same thing: credit risk.

In simple terms, bonds rated below “investment grade” are known as high-yield bonds. Moody’s classifies high yield as any bond rated below Baa3, such as Ba1 or Ba2. S&P uses a similar cutoff, defining high yield as anything below BBB-. Under S&P’s system, this includes ratings like BB+ and BB.

High yield bonds vs other types of bonds

Many investors used bonds as a way to reduce the risk in an equity-heavy portfolio and add in some much-needed diversification. They will often use government bonds and investment grade corporate bonds for that purpose, so where do high yield bonds UK sit in this universe?

Basically, they are bonds with a little extra spice. They offer more potential upside than other fixed income solutions, but the increased risk means they sit between bonds and equities. As investors may find themselves choosing between high yield bonds and investment grade corporate bonds, we have included a table to highlight the differences. We’ve also included UK gilts, which are bonds issued by the UK government, and are regarded as being extremely safe, as there’s very little risk of the country going bust.

*Moody’s ratings **S&P ratings

Potential benefits of high yield bonds

So, why should investors consider high yield bonds? Well, the answer is the chance to enjoy a better income and diversify their existing holdings.

High yield bonds have the potential to provide a better return than traditional cash savings accounts, government bond positions, and many investment grade corporate bonds. When they are working well, they offer equity-like returns with lower volatility than shares over the longer term. However, this is not guaranteed.

Then there are the diversification benefits.

Having a broad spread of assets makes sense for most people, as it reduces risk while increasing the chances of their overall asset mix making money. How an investor chooses to use them in their portfolio will depend on what they’re trying to achieve and the assets they already have. For example, they may be chosen by investors wanting to increase the yield on a fixed income part of their portfolio that’s heavily exposed to investment grade paper.

Conversely, high yield bonds can help to slightly de-risk an equity allocation, while still ticking the growth and income boxes. Once again, it’s important to stress there are no guarantees. Seeking higher returns usually comes with more risk. Investors must decide if they are comfortable with the potential downsides.

Key risks of high yield bonds

High yield bonds come with a warning. The companies or governments that issue them are judged to be at greater risk of running into trouble than those rated investment grade. This means they may fail to make interest payments and not return the principal payments. If a company defaults in this way, investors may only recover a fraction of their investment – if any at all. This is why it’s important not to invest what you can realistically afford to lose. Sinking every penny you possess into high yield bonds is certainly not advisable.

However, defaulting is not the only risk. Even if the company issuing the bond is in good health, the bond’s market value will be affected by interest rates. Generally, when interest rates rise, existing bond prices fall because the coupon rate the issuer pays now looks less attractive. The opposite is also true. When interest rates fall, bond prices rise.

On top of these risks, investing directly in high yield bonds is highly complex. Understanding bond covenants, credit agreements and the nuances of each issuer requires specialist knowledge. For this reason, we strongly encourage gaining exposure to high yield bonds through a professionally managed fund. Fund managers and their expert teams have the skills and resources to analyse issuers, monitor risks and select bonds that align with investors’ objectives, something that’s very difficult to do on your own.

Where high yield bonds sit in the bond spectrum

High yield bonds certainly sit at the riskier end of the spectrum. Here we rank the different parts of the fixed income family, from lowest to highest risk, to illustrate the point.

• Government bonds
  Bonds issued by stable governments, such as the UK, are the lowest risk. However, the interest rate being paid is also low.
• Investment grade corporate bonds
  The next step up the risk ladder. These are generally high-quality companies, so they are considered low to moderate risk. The interest rate on offer will be broadly similar to government bonds.
• Corporate bond funds
  These are investments where a manager buys a variety of individual corporate bonds. The risk taken will depend on their approach, so investors must do their research.
• Strategic bond funds
  These are pretty flexible portfolios. Managers of these funds have scope to invest across the fixed income spectrum, including high yield, investment grade and government bonds.
• Global bonds
  The risk taken depends on the type of global bonds bought. For example, developed market bonds are better researched and less risky than those issued in emerging markets. They can also be more volatile.
• High yield bond funds
  These are high up the risk scale. The only reason they’re not at the top is that these portfolios will have a diversified list of high yield names. This spreads the risk.
• High yield bonds
  Individual high yield bonds, as we have discussed, offer the highest potential returns, but because they come from lower-rated issuers, they carry a significant risk of default and price volatility.
• Emerging market bond funds
  These funds invest in bonds issued by governments or companies in emerging economies. They typically offer higher yields than developed market bonds, but can carry additional risks such as political instability, currency fluctuations, and less transparency.

How much of a portfolio might go into high yield bonds?

There’s no single “correct” amount of a portfolio to put into high-yield bonds. Instead of thinking in percentages, it’s usually more helpful to think in terms of risk. As we’ve outlined, high-yield bonds sit between investment-grade bonds and equities on the risk spectrum. For that reason, many investors view high yield as one component of a broader portfolio rather than a core holding on its own.

The right allocation for you, will depend on several factors:

• Financial goals
• Risk appetite
• Existing assets held
• Investment time horizon

For illustration only, some diversified portfolios might include a small single-digit percentage in high yield, while others may allocate a low-to-mid-teens share, depending on the mix of assets and risk appetite.

Remember, high yield is unlikely to be the only fixed income exposure for most investors and is often paired with higher-quality bonds for balance. If you’re unsure how high-yield bonds might fit into your own situation, it can be sensible to seek independent financial advice before making any decisions.

How to choose a high yield bond fund

When you’re looking for high yield bonds to invest in, it’s important to realise that no two portfolios will be exactly the same. That’s why you need to do your research – and ensure that it meets your needs. Here are key issues to consider that you can find by reading each fund’s factsheet and Key Information Document.

• Credit quality: Examine how much of the fund’s assets are in higher-rated high yield names and those that are at the lower end. This will illustrate how much risk you’ll be taking.
• Duration (interest rate risk): This shows you how sensitive the fund will be to interest rate changes. Generally, high yield bonds are less affected, but it’s still something to consider.
• Geographic focus: Where in the world is the fund invested? Is it very diversified or concentrated in a handful of countries? Does it favour developed regions, or is there a lot of emerging market exposure?
• Sector exposure: Is it also diversified by sector? For example, does it have exposure to everything from financials and retail names to telecoms and technology, or is it focused on a handful of areas?
• Charges and costs: These are often overlooked but can have a major impact on your overall returns. Ensure you know how much you’re being charged and how this compares with rival funds. Prioritise the Expense Ratio.

There’s certainly no shortage of high yield bond funds available – but you can narrow the investment universe by using FundCalibre’s shortlist of preferred portfolios.

Elite Rated and Elite Radar high yield bond funds

FundCalibre can help kick-start your search. Elite Rated portfolios have passed our quantitative screen and detailed qualitative analysis. They represent a relatively small percentage of funds in the sector. Elite Radar funds, meanwhile, are portfolios that look promising but which are still building their track record. They are worth putting on a watchlist.

Is a high yield bond fund right for you?

If you’re after a higher level of income – and are willing to accept more risk in pursuit of this goal – then the answer could be yes. You’ll also need a multi-year investment horizon and be willing to endure short-term volatility without having sleepless nights.

Income investors looking to increase the yield on a fixed income portfolio and equity investors looking to de-risk their overall asset mix may find them interesting.

If you’ve got very low risk tolerance or only have a short time before needing to access your money, then high yield bond funds are unlikely to be suitable.

It’s important to remember that returns aren’t guaranteed, and past performance shouldn’t be used as a guide to what you can expect. Remember, it’s always worth using FundCalibre’s educational resources and seeking professional financial advice before making a final decision.

How to invest in high yield bond funds

Here is our five-step journey to buying high yield bonds:

1. Be clear on your investment objectives and risk tolerance.
2. Decide how a high yield bond fund will sit alongside your existing assets.
3. Use FundCalibre’s research to draw up a shortlist of funds.
4. Compare platforms or providers if you don’t have one you use.
5. Place the fund in a chosen wrapper, such as an Individual Savings Account.

High yield bonds FAQs