A High-Yield Bond is that type of a bond, which is rated below the investment grade. It is also known as non-investment grade bond or junk bond. There is a high risk of default so a high rate of return or yield is offered. This is done in order to attract the investors. They lack “maintenance covenants” but include “incurrence covenants”. They are not similar to most investment grade bonds or bank debts.
There are two kinds of risk involved in a High-Yield Bond. They are Credit Risk and Interest Rate risk. Interest Rate risk is related to the change of a bond's value as a result of changes in the interest rate level or structure. The Credit Risk is related to the probability that a default may occur (the borrower may not be able to make payments of principal and interest) along with another probability that after the default has occurred, the interest and principal in arrears are not received. The risk is described by a Credit Rating Agency with the help of a Credit Rating like AAA. The three main Credit Rating Agencies in the U.S.A. are Fitch Ratings, Moody's, and S&P. In other countries, U.S. Credit Rating Agencies or local agencies such as the Dominion Bond Rating Service (DBRS) in Canada rate bonds. The Rating Scales differ. In order of increasing risk, the most common scales used are AAA, AA, A, BBB, BB, B, CCC, CC, C. D is used as an additional rating which refers to debt already in arrears. The Government Bonds are considered as rated above AAA or having a zero-risk category.
Investment grade bonds are those bonds that are rated BBB- and higher than that. The Bonds that have a credit rating lower than investment grade bonds are informally termed as junk bonds.
The High-Yield Bonds are categorized into nine types:
- Convertible bonds
- Deferred-interest bonds
- Extendable reset notes
- Floating-rate and increasing-rate notes
- Multi-tranche bonds
- Pay-in-kind bonds
- Straight cash bonds
- Split-coupon bonds
- Zero-coupon bonds (“zeros”)
