High-Yield Bonds (Junk Bonds): Higher Income, Higher Risk
High-yield bonds pay 3-6% more than investment-grade bonds. But they're called 'junk' for a reason — default rates average 3% per year and can spike to 15% during recessions. Here's how to evaluate high-yield bonds.
High-yield bonds, also called junk bonds or speculative-grade bonds, are corporate bonds rated below investment grade — BB+ and below by S&P, Ba1 and below by Moody's. These bonds offer higher yields to compensate investors for higher default risk. Companies issue junk bonds when they need capital but have not yet achieved investment-grade credit ratings, or when they are funding leveraged buyouts or distressed refinancing. The high-yield market is approximately $1.5 trillion in size, providing substantial opportunity for income-focused investors willing to accept additional risk.
Real-world example: HYG (a high-yield ETF) yields 7.5% compared to BND (investment-grade aggregate) at 4.5%. Over the 10 years from 2014 to 2024, HYG returned 3.8% annualized versus BND at 1.5% — outperforming by 2.3% annually. But HYG had drawdowns of -22% during the 2020 COVID crash versus BND at -18%. During 2022, HYG fell 11% and BND fell 13%. Correlation between high-yield and stocks increases during crises, reducing the diversification benefit. Compare high-yield and investment-grade bonds side by side
Rating Categories: Investment Grade vs High Yield
Credit ratings determine whether a bond is investment grade or high yield. Investment-grade bonds are rated AAA to BBB- by S&P (Aaa to Baa3 by Moody's). High-yield bonds are rated BB+ to D by S&P (Ba1 to C by Moody's). Ratings of C and D indicate default or likely default. The difference between the highest junk rating (BB+) and the lowest investment-grade rating (BBB-) can be just one notch, but it dramatically changes which institutional investors can buy the bond. Many pension funds, insurance companies, and bond funds are restricted to investment-grade bonds only.
Yield Premium and Spreads
High-yield bonds offer higher yields to compensate for higher default risk. The spread is the difference between a high-yield bond's yield and a Treasury yield of the same maturity. Normal spreads range from 3% to 5%. During financial crises, spreads can widen to 10% to 20% or more as investors demand much higher compensation for risk. In March 2020, high-yield spreads spiked to over 20% as COVID fears gripped markets, creating a buying opportunity for investors who could tolerate short-term volatility. Spread compression — when spreads narrow — typically happens during economic expansions and drives high-yield outperformance. How government and corporate bonds compare
Default Rates and Recovery Rates
The historical average default rate for high-yield bonds is approximately 3% per year. During recessions, default rates spike to 5% to 15% — in 2008 defaults reached 12%, and in 2020 they peaked at 6%. Recovery rates vary by seniority: senior secured bonds recover 50% to 70% of face value in default, senior unsecured bonds recover 30% to 50%, and subordinated bonds recover only 10% to 30%. The expected loss on a high-yield bond is the default rate multiplied by (1 minus recovery rate). For a BB-rated bond with a 1% default rate and 50% recovery, the expected loss is just 0.5% per year, which is more than covered by the yield premium.
Fallen Angels and Rising Stars
Fallen angels are bonds that were originally issued as investment grade but were downgraded to junk. Examples include Ford, GE, and Kraft Heinz. Fallen angels may offer value if the downgrade was temporary and the company can improve its credit profile. Rising stars are junk bonds that get upgraded to investment grade — the bond price typically rises on the upgrade announcement as new institutional buyers enter the market. Identifying potential rising stars is one of the most profitable strategies in high-yield investing. Build a bond ladder with high-yield bonds
How to Invest in High-Yield Bonds
Individual high-yield bonds require large minimum investments ($100,000 or more for proper diversification), extensive credit research, and significant liquidity risk. For most investors, high-yield ETFs are the better choice. Popular options include HYG (iShares High-Yield Corporate Bond ETF) with a 0.49% expense ratio, JNK (SPDR High-Yield Bond ETF) at 0.40%, and USHY (iShares Broad USD High-Yield Bond ETF) at 0.22%. Active high-yield mutual funds can add value by avoiding defaults better than passive index funds. The best approach for most investors is to limit high-yield to 5% to 15% of the total bond portfolio, treating it as an equity-like complement to core bond holdings.
What is the difference between investment-grade and high-yield bonds?
Investment-grade bonds are rated BBB- or higher by S&P and have low default risk. High-yield bonds are rated BB+ or lower and have significantly higher default risk. Investment-grade bonds offer lower yields but behave more like traditional bonds, providing stability and diversification against stocks. High-yield bonds offer higher yields but behave more like stocks during market stress — they tend to fall when stocks fall, reducing their portfolio diversification benefit. Over the long term, high-yield bonds have delivered higher returns but with much higher volatility and larger drawdowns during recessions.
Are junk bonds a good investment?
Junk bonds can be a good investment when held in the right context. They work best as a small allocation within a diversified bond portfolio for investors seeking higher income who can tolerate drawdowns of 15% to 25% during recessions. They are less suitable for conservative investors, retirees relying on portfolio withdrawals during downturns, or anyone who cannot tolerate significant short-term losses. The best time to buy high-yield bonds is when spreads are wide (above 5% to 6%), indicating high compensation for default risk. Buying when spreads are tight (below 3%) offers less compensation for the risk taken.
What is a fallen angel bond?
A fallen angel is a bond that was originally issued with an investment-grade rating but has been downgraded to high-yield status. These bonds often experience price declines on the downgrade as institutional investors are forced to sell. Fallen angels can present buying opportunities if the downgrade is temporary and the company can improve its financial position. The Fallen Angel Bond Index has historically outperformed the broad high-yield market because these bonds tend to be larger, more liquid companies that eventually recover their credit standing. ETFs like FALN specifically track fallen angel bonds.
How do default rates affect high-yield bond returns?
Default rates directly impact high-yield returns. When defaults rise, bond prices fall as investors demand higher compensation for risk, and actual principal losses occur. Historical average default rates of 3% per year are already priced into high-yield yields. The risk occurs when defaults spike unexpectedly — during the 2008 financial crisis, the 12% default rate caused significant losses even after accounting for the higher yield premium. Recovery rates matter too: if you expect a 50% recovery on defaulted bonds, the loss from a 3% default rate is only 1.5% per year. Diversification across many issuers is critical because individual defaults are unpredictable.
Related Resources
Bonds Investing for Beginners
A complete guide to fixed income, from Treasuries to high-yield.
High-Yield vs Investment-Grade
Compare junk bonds with investment-grade bonds side by side.
Government vs Corporate Bonds
Understand the risk and return differences across bond types.
Bond Ladder Strategy
How to build a ladder with high-yield and investment-grade bonds.
Investing During a Recession
How high-yield bonds perform in economic downturns.
Treasury Bills, Notes, and Bonds
Understand the risk-free benchmark for all bond yields.