Investment-grade corporate bonds (LQD) carry inferior yields compared to high yield bonds (JNK) with the same maturity date. Yield is a rate of return anticipated on the bond if held until maturity. Yield-to-maturity or YTM tends to move in line with changes in interest rates. If interest increases, the price of a bond decreases to compensate for the lower yield-to-maturity (rate of return) and vice versa. High yield bonds pay a lofty yield-to-maturity due to the lower rating of the issuer and high risk associated with the fixed income asset class.
Default rates essentially represent a chance of corporate defaulting on the interest and principal payment at the time of distress. Except for U.S. government bonds, all other fixed income carries default risk. The degree of risk depends on many factors. However, other things being equal, the higher the credit rating, the lower the default risk. Investment-grade bonds, due to their better credit profile, carry less default risk than high yield bonds.
Maturity is the date when a bond will be redeemed for its par value. A bond can be redeemed before the maturity date in accordance with the bond’s call provision. Typically, bonds can only be called at or above par. The sooner the bond is called off by an issuer, the higher the premium that the issuer may have to pay to bondholders to compensate for the loss on the interest rate payment—which otherwise could have yielded if the bond had been held until maturity.
Investment-grade corporate bonds have a similar maturity profile to U.S. Treasuries. Bonds can be issued with various maturity dates, from a few months to few years. The highest maturity can go is 30 years. On the other hand, high yield bonds usually have maturities between seven and ten years.
Since high yield bonds are riskier than investment-grade corporate bonds, they tend to have strict restrictions on the coverage ratios the company is required to follow when incurring a new debt. These restrictions are called “covenants.” High yield bonds carry incurrence-based covenants that need the issuer to comply with certain financial metrics. These financial metrics are set by the borrower, and they need to be tested when a relevant corporate action takes place. However, investment-grade corporate bonds are issued by large corporations with a proven track record and good credit ratings, so they’re perceived as safer than high yield bonds.
Volatility varies in investment-grade corporate bonds and high yield bonds based on the issuer’s earnings or financial performance. There are many metrics used to gauge the financial performance of a company. However, some general ratios that an investor could look upon fall under two main categories, leverage ratios and coverage ratios. Leverage ratios measure how much debt a company has on its cash flow generation ability. The most common ratios used are total debt–to–EBITDA (earnings before interest, tax, depreciation, and amortization), also called “total leverage” or “gross leverage,” and net debt–to–EBITDA, also called “net leverage.” There are other ratios used depending on the industry, such as debt–to–free cash flows or net debt–to–retained cash flows.
To be considered investment-grade, companies usually need to have total leverage values below 2.0x. High yield bonds, though more volatile, tend to compensate the risk by paying higher yield compared to investment-grade corporate bonds.
In the next part of this series, we’ll learn more about some important investment-grade corporate bonds and high yield bond ETFs that investors may consider to get the exposure in this asset class.