What is High-Yield Bond (Junk Bond)? (Plain English Definition)
Definition: A high-yield bond is a bond rated below investment grade that pays higher interest to compensate for its greater risk of default.
High-Yield Bond (Junk Bond) Explained Simply
High-yield bonds, also called junk bonds, are bonds issued by companies or entities with lower credit ratings -- typically BB+ or below from S&P, or Ba1 or below from Moody's. These issuers are considered to have a higher risk of defaulting on their debt payments, so they must offer higher interest rates to attract investors.
High-yield bonds occupy a middle ground between investment-grade bonds and stocks in terms of risk and return. They typically offer yields 3-5 percentage points higher than Treasury bonds of similar maturity. Their prices are more volatile than investment-grade bonds and are influenced by both interest rate changes and the creditworthiness of the issuers.
High-yield bond ETFs provide diversified exposure to hundreds of junk bonds, which is important because any individual high-yield bond has a meaningful chance of defaulting. By holding hundreds of bonds, the ETF ensures that defaults by a few issuers do not devastate the overall portfolio. Popular high-yield bond ETFs include iShares iBoxx High Yield Corporate Bond ETF (HYG) and SPDR Bloomberg High Yield Bond ETF (JNK).
High-Yield Bond (Junk Bond) Example
The iShares iBoxx High Yield Corporate Bond ETF (HYG) holds about 1,200 bonds with an average credit rating of BB. It yields approximately 7%, compared to about 4.5% for an investment-grade bond ETF. However, during the 2020 COVID crisis, HYG fell about 20% in a month while investment-grade bond funds fell only 6-8%. The higher yield comes with meaningfully higher volatility and drawdown risk.
Why High-Yield Bond (Junk Bond) Matters for ETF Investors
High-yield bond ETFs can play a role in a diversified portfolio by providing income higher than investment-grade bonds. However, their risk profile is closer to stocks than to safe bonds, so they should not be used as a substitute for your core bond allocation. For ETF investors, a small allocation to high-yield bonds (perhaps 5-10% of a portfolio) can boost income without dramatically increasing risk, thanks to the diversification within the ETF. But it is crucial to understand that high-yield bonds will likely decline during the same market crises that hurt stocks, so they do not provide the same safe-haven protection as Treasury bond ETFs.
High-Yield Bond (Junk Bond) vs Bond
| High-Yield Bond (Junk Bond) | Bond |
|---|---|
| A high-yield bond is a bond rated below investment grade that pays higher interest to compensate for its greater risk of default. | See full definition of Bond |
While high-yield bond (junk bond) and bond are related concepts, they serve different purposes in the world of ETF investing. Understanding both terms helps you make more informed decisions about which funds to include in your portfolio and how to evaluate their performance.
Related Terms
Deepen your understanding of ETF investing by exploring these related concepts:
Bond
A bond is a fixed-income investment where you lend money to a government or corporation in exchange for regular interest payments and the return of principal at maturity.
Credit Rating
A credit rating is an assessment of a bond issuer's ability to repay its debt, assigned by rating agencies like Moody's, S&P, and Fitch.
Default Risk
Default risk is the probability that a bond issuer will fail to make required interest payments or return the principal amount at maturity.
Fixed Income
Fixed income refers to investments that provide regular, predictable interest payments, primarily bonds and bond-like securities.
Yield to Maturity (YTM)
Yield to maturity is the total return anticipated on a bond if held until it matures, accounting for coupon payments, current price, and the face value received at maturity.
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