Any investor offering advice on smart(er) investing will, at one point, steer you in the direction of bonds. I am no different in that regard as bonds offer plenty of benefits for investors such as having a fixed amount of income at regular intervals, less risk than stocks, and being a welcome addition to portfolio diversification – among other things.
Bonds are fixed-income, interest-bearing instruments that occur when an investor lends money to the bond issuer (companies, governments) for a specific project in exchange for interest payments. Think of them as a way for organizations to raise funds, paying back the investment with interest over a specific timeframe.
Naturally, not all bonds are the same. They have two main classifications that I’ll focus on with this post: high-yield vs. investment-grade.
Investment-grade vs high-yield credit ratings
To invest, there first needs to be a sound estimate of the bond issuer’s ability to meet its commitments. That’s what credit ratings are for – measures of solvency and the probability of default, assigned by rating agencies such as S&P Global Ratings (S&P), Moody’s, and Fitch Group (also known as ‘the big three’). Investors use these ratings as benchmarks when making investment decisions.
Here’s how those ratings look like:
As you can see, the alphabetic scores ascertain whether a bond is an investment-grade or high-yield one. The AAA/Aaa rating represents the best credit quality with a negligible risk of default, while anything below BBB/Baa is treated as high yield bonds. Credit ratings can be as low as D which signifies that the issuer is currently in default.
That means that organizations with high solvency issue investment-grade bonds while high-yield bonds (also known as speculative or junk bonds) are reserved for issuers with a lower credit rating because of their weaker competitive position, small(er) size of operational diversification (or lack thereof), general indebtedness policies, etc. The same principle holds for government bonds – China’s debt might be ranked investment-grade while Venezuela’s might be deemed high-yield.
With the majority of ”work” carried out by external rating agencies, the good news for investors is that it is fairly straightforward to assess the risk profile of a bond. While these are clearly identified as point-in-time ratings, a credit rating is typically monitored on an ongoing basis and reviewed at least once every 12 months. For instance, in 2010, Standard & Poor decreased the Greek debt rating to junk status amid fears of default by the Greek government.
High-yield vs investment-grade major differences
There are three key differences between these categories of bonds:
- Level of risk
- Amount of returns
- Maturity terms
It’s considered and widely accepted that bonds rated as investment-grade have a lower return and are less risky than those labeled as high-yield. High-yield bonds usually come with more risk as the issuers are evaluated to have a greater chance of default but they also offer higher returns as a reward of sorts for investors for taking a shot with them, so to speak. As for maturity terms, investment-grade bonds have longer terms as they reap the benefit from existing interest from more conservative and investors seeking more stable and long-term investment opportunities (a pension fund would be a good example).
Which one is better?
In the debate of high yield vs investment-grade bonds, I don’t take sides as there is no clear winner – it all depends on your investment risk tolerance.
Different bonds won’t appeal the same way to different investors. The high-yield bond is a better fit for an investor who is willing to accept a certain degree of risk to receive a higher return. The risk ( the most significant one) is that the company or government issuing the bond will default on its debts. Even diversification, arguably the best way to deal with such a situation, restricts the maneuverability and adds to increases in fees for investors.
Then again, investment-grade bonds aren’t perfect as fixed income securities carry interest rate risk. Despite being designated as less risky than investing in stock markets which are prone to greater volatility, the bond market is still volatile enough to see prices fall dramatically as interest rates rise – an effect more noticeable on longer-term securities. In addition, there are also inflation, liquidity, and other kinds of risks involved (always a good idea to brush up on various investing risks) for both issuers and investors.
As one of the major risk tolerance factors, it’s not unusual (though no rule of thumb) that age plays a significant role in bond investing. Investors in their 20s and 30s have the luxury of time to recoup any capital losses and survive the market fluctuations (sudden downturns are a frequent occurrence) so they can afford to be aggressive with their investments and opt for adding high yield issues to their diversified portfolio.
On the other hand, older investors (especially those facing retirement) tend to think about long-term financial security and preserving capital, typically having lower risk tolerance and focus on more stable investments such as investment-grade bonds.
At the moment of writing, the world is going through uncertainty in the face of the COVID-19 pandemic, which is conversely a great example of market volatility. The spread between high-yield and investment-grade bonds – the difference in the yield on high-yield bonds and a benchmark bond such as investment-grade – is increasing in some cases and/or is expected to so. It’s a sign of higher default risk in junk bonds and somewhat reflects the overall corporate economy today and subsequently, credit ratings.
Right now, with the possibility of a recession, high-yield bonds tend to perform poorly and I wouldn’t be comfortable taking a risk. On the other hand, if you’re a believer like I am, we’re due for a period of economic expansion and I would aim for an investment then as higher-yielding bonds generally outperform lower-yielding ones during times of growth.
Historically speaking, high-yield bonds have been much more volatile than their investment-grade counterparts and the trend is likely to continue. However, even investment-grade bonds can quickly lose their value and fall below investment grade, which just goes to show why it’s important to know what you’re investing in. It’s the best advice I can give you right now.