High yield or junk bonds

Bond ratings run on a scale from very safe to very risky, and market convention draws a clear line partway down that scale.

Bonds rated BBB and above are called investment grade. Everything below BBB — BB, B, C and D — is called high yield, or more bluntly, a junk bond. The lower the rating, the higher the chance the issuer fails to pay on time, or at all.

Many institutional investors are simply not allowed to hold junk bonds, whatever the potential return, because the default risk is judged too high for the mandates they operate under.

SEBI-registered rating agencies use an 8-tier scale: AAA (highest safety), AA (high safety), A (adequate safety), BBB (moderate safety) — the 4 investment-grade tiers — followed by BB (moderate risk), B (high risk), C (very high risk) and D (default) — the 4 high-yield tiers.

The credit spread — the extra yield a corporate bond pays over a government security of the same maturity — rises as the rating falls, because it compensates the investor for bearing more default risk. A junk bond therefore offers a higher yield than an investment-grade bond precisely because it is riskier, not despite it.

Series XXI-B's workbook adds how a high yield manager actually works, which this paper does not cover: the focus is on short-dated securities with high earnings visibility, and the analysis is of what a holder would recover in liquidation rather than of interest rates and spreads. That is XXI-B chapter 19's framing, named here because it explains why a high yield portfolio is run as credit work rather than as duration work.

A company's bond is rated BBB, the lowest investment-grade tier, and yields 8.5%, against a comparable government security yielding 7% — a credit spread of 1.5 percentage points.

A second company, rated BB — one notch below investment grade — is now classed as a junk bond. To attract buyers despite the higher default risk, it has to offer a much wider spread, say 9.5% against the same 7% government benchmark, a 2.5 percentage point spread. Many mutual fund schemes and pension funds are simply barred by their own mandates from buying that second bond, however attractive the extra 2% of yield looks.

Chapter 7 (Introduction to Investments), 'High Yield versus Investment Grade', gives the full eight-tier rating scale and draws the BBB cut-off. Expect a question naming the rating below which a bond becomes high yield or junk, or one on why institutional investors avoid junk bonds despite the higher yield.

• The cut-off is BBB and above for investment grade; below BBB is high yield/junk — BBB itself is still investment grade, a common point of confusion.
• A higher rating means lower credit risk, and the scale runs from AAA (safest) down to D (default) — do not read the letters in the opposite direction.
• Many institutional investors are prohibited from investing in junk bonds by their own mandates, not by law directly — this is a portfolio-construction constraint as much as a regulatory one.