Are high-yield bonds better investments than low-yield bonds?

Most bonds typically make periodic payments, known as coupon payments, to the bondholder. A bond's
indenture, which will be known when the purchaser buys the bond, will specify the coupon payments to
be paid by the bond.

Different companies will issue different bonds to raise financial capital, and the quality of each bond
is determined by the quality of the issuing firm, which depends on the firm's ability to pay all coupon
payments and the principal at maturity. The yield offered is used to compensate investors for the risk
they incur when purchasing a given company's bond. The higher the yield, the more likely it is that the
firm issuing the bond is not of high quality - in other words, the more likely the firm is to not
make coupon and principal payments. When a firm misses a payment, the bond is said to be in default,
and the risk that this will happen is known as default risk.

Bonds rated 'BB' or lower on the bond rating scale are considered lower grade (junk or speculative)
bonds and carry a larger amount of default risk than a bond that is rated above 'BB' (also known as
investment grade). The highest rating a bond can have is 'AAA', and the lowest is 'CCC'. A rating of 'D'
indicates the bond is in default. (To learn more, see What Is A Corporate Credit Rating?)

So, which bond is better to purchase? It depends on the amount of default risk you as an investor want
to be exposed to. If the issuer does not default, the higher yield bond will give you a higher return, in the
form of coupon payments, but the default risk is higher than what you would face with a lower yield,
higher grade bond. If you purchase a higher grade, lower yield bond, you are exposed to less default
risk, and you have a higher chance of getting all of the promised coupon payments and the par value if
you hold the bond to maturity.

For more information on high- and low-yield bonds, see High Yield, Or Just High Risk?, Junk Bonds:
Everything You Need To Know and our Bond Basics Tutorial.
Can a bond have a negative yield?

The return a bond provides to an investor is measured by its yield, which is quoted as a percentage.

Current yield is a commonly quoted yield calculation, used to evaluate the return on a bond for a one-
year period. It only accounts for the interest, or coupon payments, that the bond returns to investors.
This yield is calculated as the bond's coupon rate divided by its current market price, but it does nothing
to account for any capital gains or losses when the bond is sold. If the bond is not sold within the year,
this yield calculation will provide the bondholder with an accurate assessment of his or her return. The
only way a bond's current yield could be negative, using this basic evaluation, is if the investor were
receiving negative interest payments, or if the bond somehow had a market value below $0 - both of
which are very unlikely to occur.

Other yield calculations will take into account different factors and can be used to better evaluate the
returns an investor may receive, given different events.

As its name suggests, the yield to maturity (YTM) calculates the return (expressed as an

annual percentage) on a bond if the investor were to hold the bond until maturity. This formula takes
into account all of the coupon payments and the face - or par - value on the bond (assuming no principal
defaults), and it can be seen as a more complete evaluation than current yield. However, calculating a
bond's YTM is complex and involves trial and error. It is usually done by using a programmable business
calculator, but you can also get an approximate YTM by using a bond yield table.

Let's consider an example: say an investor pays $800 for a bond that has has exactly two years to
maturity, a face value of $1,000 and interest payments of $8 per year. Using a bond table, we could
determine that the bond will have a YTM of about 10.86%. If the bond holder paid $1,200 for the bond,
the YTM would be about -9.41%  (It is worth noting, however, that a bond will not necessarily have a
negative actual yield just because the investor paid more than face value for it.) When using the YTM
calculation, it is possible to have a negative yield on a bond - it depends largely on how much you
initially pay for the bond and the time to maturity.

Yields can be calculated using different formulas - there are many more than the two mentioned here -
and depending on the formula used, you can end up with drastically different yields. To learn more, see
our Bond Basics Tutorial, Advanced Bond Concepts and The Basics Of The Bond Ladder.
Are High-Yield Bonds Too Risky?

It may surprise you to know that some of the top companies in the Fortune 500 have had debt
obligations that were below investment grade - otherwise known as "junk bonds". For example, in 2005,
automotive icons Ford and General Motors both fell into junk bond status for the first time in either
company's history. Many investors would not pass up the opportunity to buy common stock in these
companies, so why do so many avoid these companies' bonds like the plague? It may have something to
do with price fluctuation and with the fear that past abuses, like those of Michael Milken - the
controversial financial innovator also known as "The Junk Bond King" - might be repeated.

Although they are considered a risky investment, junk bonds may not deserve the negative reputation
that still clings to them. In fact, the addition of these high-yield bonds to a portfolio can actually reduce
overall portfolio risk when considered within the classic framework of diversification and asset
allocation. Here we explain what high-yield bonds are, what makes them risky and why you may want to
incorporate these bonds into your investing strategy.

Why the Bad Reputation?

During the 1980s, Michael Milken - then an executive at investment bank Drexel Burnham Lambert Inc -
gained notoriety for his work on Wall Street. He greatly expanded the use of high-yield debt in corporate
finance and mergers and acquisitions, which in turn fueled the leveraged buyout boom. Milken made
millions of dollars for himself and his Wall Street firm by specializing in bonds issued by "fallen angels" -
companies that experienced financial difficulty which caused the price of their debt, and subsequently
their credit rating, to fall.

In 1989, Rudy Giuliani (then the U.S Attorney General of New York) charged Milken under the RICO Act
with 98 counts of racketeering and fraud. Milken was indicted by a federal jury. After a plea bargain, he
served 22 months in prison and paid over $600 million in fines and civil settlements. Today, many on
Wall Street will attest that the negative outlook on junk bonds still persists because of the questionable
practices of Milken and other high-flying financiers like him. 

Defining High-Yield Investments

Generally, high-yield bonds are defined as debt obligations with a bond rating of Ba or lower according
to Moody's, or BB or lower on the Standard & Poor's scale. (To learn more, see What Is A Corporate
Credit Rating?) In addition to being popularly known as "junk bonds", they are also referred to as
"below-investment grade". These bonds are available to investors as individual issues or through high-
yield mutual fund investments. For the average investor, high-yield mutual funds are the best way to
invest in junk bonds, as these funds were formed to diversify a pool of junk bonds and reduce the risk of
investing in financially struggling companies.
 
Advantages of High-Yield Bonds
Many good companies run into financial difficulty at various stages of their existence. One bad year for
profits or a tragic chain of events may cause a company's debt obligations to be downgraded to a level
below investment grade. Because of these additional risks, high-yield investments have generally
produced better returns than higher quality, or investment grade, bonds. If you are looking to get a
higher yield within your fixed-income portfolio, keep in mind that high-yield bonds have typically
produced larger returns than CDs, government bonds and highly-rated corporate issues.

High-yield bonds do not correlate exactly with either investment-grade bonds or stocks. Because their
yields are higher than investment-grade bonds, they're less vulnerable to interest rate shifts, especially
at lower levels of credit quality. And, as Susan Weiner explains in an article in Financial Planning
Magazine, they are similar to stocks in relying on economic strength ("Proceed with Caution", Financial
Planning Magazine, Sept 2005). Because of this low correlation, adding high-yield bonds to your
portfolio can be a good way to reduce overall portfolio risk when considered within the classic
framework of diversification and asset allocation.

Another factor that makes high-yield investments appealing is the flexibility that managers are given to
explore different investment opportunities that will generate higher returns and increase interest
payments. Finally, many investors are unaware of the fact that debt securities have an advantage over
equity investments if a company goes bankrupt. Should this happen, bondholders would be paid first
during the liquidation process, then preferred stockholders, and lastly common stockholders. This added
safety can prove valuable in protecting your portfolio from significant losses, thereby improving its long-
term performance.

The New High Yield

If you're looking for some big yield premiums, then emerging market debt securities may be a good
addition to your portfolio. Typically, these securities are cheaper than their U.S. counterparts because
they have a much smaller market, yet they account for about 30% of global high-yield markets. Since the
U.S. represents only 50% of global high-yield markets, those investors who stay domestic are missing out
on a broad range of opportunities in the global markets.

What else could you be purchasing when investing in high-yield funds? One new addition is leveraged
bank loans, which are often defined as credits priced 125 basis points or more over the London
Interbank Offer Rate (LIBOR). These are essentially loans that have a higher rate of interest to reflect a
higher risk posed by the borrower. Some managers like to include convertible bonds of companies
whose stock price has declined so much that the conversion option is practically worthless. These
investments are commonly known as "busted convertibles" and are purchased at a discount since the
market price of the common stock associated with the convertible has fallen sharply.

To help diversify their investments even further, many fund managers are given the flexibility to include
high-yielding common stocks, preferred stocks and warrants in their portfolios, despite the fact that
they are considered equity products. For portfolio managers looking to tailor duration and short the
market, credit default swaps offer a credit derivative that allows one counter-party to be long a third-
party credit risk and the other counter-party to be short the credit risk. In essence, one party is buying
insurance and the other party is selling insurance against the default of the third party.
Risks of High-Yield Investing

High-yield investments also have their disadvantages, and investors must consider higher volatility and
the risk of default at the top of the list. Fortunately for investors, default rates are currently around 2%
(as of Aug 2005), which is near historic lows. However, you should be aware that default rates for high-
yield mutual funds are flawed. The figures can be manipulated easily by managers because they are
given the flexibility to dump bonds before they actually default and get downgraded and to replace
them with new bonds.

How would you be able to assess more accurately the default rate of a high-yield fund? You could look
at what has happened to the fund's total return during past downturns. If the fund's turnover is
extremely high (over 200%), this may be an indication that near-default bonds are being replaced
frequently. You could also look at the fund's average credit quality as an indicator; this would show you
if the majority of the bonds being held are just below investment-grade quality at 'BB' or 'B' (Standard &
Poor's rating). If the average is 'CCC' or 'CC', then the fund is highly speculative ('D' indicates default).

Another pitfall to high-yield investing is that a poor economy and rising interest rates can worsen yields.
If you've ever invested in bonds in the past, you're probably familiar with the inverse relationship
between bond prices and interest rates: "as interest rates go up, bond prices will go down". Junk bonds
tend to follow long-term interest rates more closely; these rates have recently stabilized, thus keeping
investors' principal investment intact. 

During a bull market run, you might find that high-yield investments produce inferior returns when
compared to equity investments. Fund managers may react to this slow bond market by turning over
the portfolio (buying and selling to replace the current holdings), which will lead to higher turnover
percentages and, ultimately, add additional fund expenses that are paid by you, the end investor.

In times when the economy is healthy, many managers believe that it would take a recession to plunge
high-yield bonds into disarray. However, investors must still consider other risks such as the weakening
of foreign economies, changes in currency rates and various political risks.

Conclusion
Before you invest in high-yield securities, you should be aware of the risks involved. If, after doing your
research, you still feel these investments suit your situation, then you may want to add them to your
portfolio. The potential to provide attractive levels of income and the ability to reduce overall portfolio
volatility are both good reasons to consider high-yield investments. 
Why do interest rates tend to have an inverse relationship with bond prices?

At first glance, the inverse relationship between interest rates and bond prices seems somewhat
illogical, but upon closer examination, it makes sense. An easy way to grasp why bond prices move
opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their
value from the difference between the purchase price and the par value paid at maturity.

For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in
one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 =
5.26%).

For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his
or her satisfaction with this return depends on what else is happening in the bond market. Bond
investors, like all investors, typically try to get the best return possible. If current interest rates were to
rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only
be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To
attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to
match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop
from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).

Now that we have an idea of how a bond's price moves in relation to interest-rate changes, it's easy to
see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%,
our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would
buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In
this instance, the price of the bond would increase to approximately $970. Given this increase in price,
you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing
interest rates.