The major bond market segment that most investors concentrate on is the high-quality sector: U.S. government bonds, high-grade corporate bonds and high-grade municipals.
These bonds offer the smallest degree of default risk, clearly a major concern to most fixed-income investors who are concerned about yearly income flows.
U.S. government bonds offer the most protection against default. However, diversification among high-grade corporate and municipal issuers can substantially reduce default risk among issuers. Municipal issues offer the added benefit of federal tax-free income.
These bonds, however, all face similar interest rate risk. Bond values are tied closely to the level of interest rates: As interest rates rise, the values of bonds fall; as interest rates fall, the values of bonds rise. Thus fluctuations in interest rates will cause the total return on bonds to fluctuate, with long-term bonds fluctuating more than short-term bonds.
Not all segments of the bond market react to interest rate fluctuations in the same manner. While high-quality bonds tend to be highly sensitive to the level of interest rates in the U.S., one other bond market segment is affected by other variables, and thus tends to behave somewhat differently. This segment is the high-yield bond market.
A high-yield corporate bond is a type of corporate bond that offers a higher rate of interest because of its higher risk of default. High-yield bonds are usually issued by firms that have an uncertain financial outlook—either they have fallen into deteriorating credit situations, they are emerging growth companies, or they are undergoing corporate restructurings. The issues are rated below investment grade by bond rating agencies.
While the returns of these bonds are affected by interest rates, they are also responsive to the overall economic cycle as well as the growth prospects of the issuing firm. Economic downturns cast major shadows on the future prospects for the issuing firms and their ability to pay their debt. Conversely, a strong economy bodes well for the firms and their bonds. This economic impact works in opposition to the interest rate risk they face: rising rates, which are bad for bonds generally, usually accompany a strong economy, which is good for high-yield bonds; falling rates, which are good for bonds overall, usually accompany a weak economy, which is bad for high-yield bonds. In addition, high-yield bonds are less sensitive to changes in interest rates due to the larger coupons received each year.
Additional risks of high-yield bonds:
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