Most bonds typically make periodic payments, known as coupon payments, to the bondholder. A bond's indenture, revealed when the purchaser buys the bond, will specify the the details of the coupon payments.
Different companies will issue different bonds to raise financial capital, and the quality of each bond is determined by the quality of the issuer, which depends on its ability to pay all coupon payments and the bond's 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.
Two major credit rating agencies evaluate the bond issuers based on their ability to pay interest and principal as required under the terms of the bond. Bonds rated "BB" or lower on the on the Standard & Poor's bond rating scale, or "Ba" or lower according to Moody's, are considered lower-grade (junk or speculative) bonds and carry a larger amount of default risk than bonds that are rated higher. The highest S&P rating a bond can have is "AAA," and the lowest is "CCC"; a rating of "D" indicates the bond is in default. In the case of Moody's, ratings range from "Aaa" to "C," with the latter indicating default.
High-yield bonds tend to be these junk bonds, with lower credit ratings. Since they have lower credit ratings, there is a higher risk of default by the corporate issuers. To entice investors to buy the bonds, the bonds pay a higher rate of interest. In contrast, the better-rated bonds – also known as investment grade – tend to have lower yields. Instead, they're offering greater security and likelihood of reliable payments.
There is a yield spread between investment grade bonds and high-yield bonds. Generally, the lower the credit rating of the issuer, the higher the amount of interest paid. This yield spread fluctuates depending on economic conditions and interest rates.
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.
The Bottom Line
Investors who are seeking yields greater than those of U.S.Treasury bonds (the gold standard of investment-grade bonds: notoriously low, but famously reliable, payments) may be willing to take on the additional risk in return for greater yield.
There are highly liquid exchange-traded funds (ETFs) that invest in high-yield debt. These ETFs allow investors to gain exposure to a diversified portfolio of lower-rated bonds. This diversification across companies and sectors can protect against default risk. Still, even with diversification, periods of high market volatility can lead to a much larger number of companies defaulting on their debt obligations.
For more information on high- and low-yield bonds, see "Are High-Yield Bonds Too Risky?," "The Fundamentals of High Yield Bond Investing" and our Bond Basics Tutorial.
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