Contents
Fixed-income investing can be a valuable cornerstone of your diversified portfolio, offering a steady stream of income and a potential hedge against market volatility. However, navigating the diverse landscape of bond types is crucial for success.
One key factor to consider when evaluating bonds is the issuer’s creditworthiness. Credit rating agencies like Moody’s, Standard & Poor’s (S&P), and Fitch assess this creditworthiness and assign ratings to bonds. These ratings reflect the likelihood of the issuer fulfilling its debt obligations.
This article will delve into a specific category of bonds: non-investment-grade bonds. We’ll explore their characteristics, potential rewards, and associated risks, providing valuable insights into your fixed-income investment decisions.
What are non-investment-grade bonds?
You’ve likely heard of bonds issued by companies with strong credit ratings that are considered “investment-grade.” However, companies with lower credit ratings issue another category of bonds: non-investment-grade bonds, high-yield bonds, speculative bonds, or even “junk bonds.”
Rating agencies like Moody’s, Standard & Poor’s (S&P), and Fitch assign these ratings. If a company’s credit rating falls below Baa3 from Moody’s or BBB- from S&P and Fitch, their bonds are considered non-investment grade.
The term “junk bonds” might sound a bit harsh, and that’s because it reflects the higher risk associated with these securities. These companies are deemed less likely to repay their debts than those with higher credit ratings.
| Rating category | Description | Moody’s | S&P global | Fitch |
| Investment grade | ||||
| AAA | Highest credit quality | Aaa | AAA | AAA |
| AA | Very strong credit quality | Aa1, Aa2, Aa3 | AA+, AA, AA- | AA+, AA, AA- |
| A | Strong credit quality | A1, A2, A3 | A+, A, A- | A+, A, A- |
| BBB | Adequate credit quality | Baa1, Baa2, Baa3 | BBB+, BBB, BBB- | BBB+, BBB, BBB- |
| Non-investment grade (high-yield, speculative, junk) | ||||
| BB | Less vulnerable | Ba1, Ba2, Ba3 | BB+, BB, BB- | BB+, BB, BB- |
| B | More vulnerable | B1, B2, B3 | B+, B, B- | B+, B, B- |
| CCC | Currently vulnerable | Caa1, Caa2, Caa3 | CCC+, CCC, CCC- | CCC+, CCC, CCC- |
| CC | Currently highly vulnerable | Ca | CC | CC |
| C | Currently highly vulnerable | C | C | C |
| D | In default | C | D | D |
Key characteristics of non-investment-grade bonds
Key characteristics of non-investment-grade bonds include:
Higher risk. Due to the lower creditworthiness of the issuers, there’s a significantly higher risk of default. If the company fails to make interest payments or repay the principal, you could lose a substantial portion of your investment.
Higher potential returns. To compensate for the increased risk, non-investment-grade bonds typically offer higher yields (interest rates) than investment-grade bonds.
Volatility. The prices of non-investment-grade bonds can fluctuate significantly more than those of investment-grade bonds. Changes in the issuer’s credit quality, economic conditions, and interest rate movements can all substantially impact their prices.
Why investors consider non-investment-grade bonds
Non-investment-grade bonds can offer compelling advantages for investors. One key benefit is the potential for higher returns. Compared to investment-grade bonds, these securities typically offer significantly higher yields. It can be particularly attractive during rising interest rates, when the value of existing bonds may decline.
Furthermore, adding non-investment-grade bonds to your portfolio can enhance diversification. These bonds may have lower correlations with other asset classes, such as stocks and investment-grade bonds. Their prices may not always move in the same direction. By including these bonds in your portfolio, you can potentially reduce portfolio risk and improve its performance.
Risks associated with non-investment grade bonds
Investing in non-investment-grade bonds comes with significant risks:
Default risk. The most significant concern is the possibility of the issuing company failing to meet its debt obligations. Investors could suffer substantial capital losses if the company cannot make interest payments or repay the principal. This risk is inherent to junk bonds due to the lower creditworthiness of the issuers.
Credit rating downgrades. A key implication of the lower credit quality is the vulnerability to credit rating downgrades. Credit rating agencies may lower their assessment if the issuer’s financial condition deteriorates. This downgrade directly impacts the bond’s perceived risk, leading to a sharp decline in its market price and potentially significant losses for investors.
Interest rate risk is prevalent across the bond market but particularly pronounced with junk bonds. As interest rates rise, the value of existing bonds, including junk bonds, typically declines. This sensitivity arises from the inverse relationship between bond prices and interest rates.
Liquidity risk. Junk bonds often exhibit lower liquidity compared to their investment-grade counterparts. Buying or selling quickly at a fair price can be more challenging. Reduced liquidity can significantly impact an investor’s ability to access their investment when needed, potentially forcing them to sell at a loss during unfavorable market conditions.
Investing in non-investment-grade bonds
Investing in non-investment-grade bonds requires careful consideration and a thorough understanding of the risks involved. Here are some important factors to keep in mind:
1. Due diligence
Thorough research is crucial before investing in any non-investment-grade bond. Analyze the issuer’s financial health, including revenue, profitability, and debt levels.
Assess their competitive position within their industry and evaluate the overall industry trends. Carefully examine the specific terms of the bond, such as its maturity date, coupon rate, and any call provisions that may allow the issuer to redeem the bond early.
2. Consider investment objectives and risk tolerance
Investing in non-investment-grade bonds should align with your investment goals and risk tolerance. These bonds carry a higher risk level than investment-grade bonds due to the increased likelihood of default. If you have a low-risk tolerance and prioritize capital preservation, non-investment-grade bonds may not suit your portfolio.
Assessing your investment time horizon carefully is crucial. If you need access to your funds in the short term, the potential for price fluctuations and lower liquidity associated with junk bonds could create challenges.
Furthermore, consider your overall portfolio diversification. If a significant portion of your portfolio is exposed to higher-risk investments, adding non-investment-grade bonds may further increase your overall portfolio risk.
3. Diversification strategies
To mitigate risk, consider diversifying your exposure to the high-yield bond market. You can invest in bonds issued by companies in different sectors.
For example, instead of focusing solely on energy companies, you could invest in bonds issued by companies in the technology, healthcare, and consumer goods sectors. Alternatively, consider investing in a diversified high-yield bond fund, which provides exposure to a broad range of issuers within the market.
4. Professional guidance
Seeking advice from a qualified financial advisor can be invaluable when considering non-investment-grade bonds. They can assess your financial situation, risk tolerance, and investment objectives to determine if these bonds suit your portfolio. A financial advisor can help you develop an appropriate investment strategy, select suitable bonds, and monitor your investments over time.
⬡ Start Your Journey Here: Fixed Income Instruments.
