Understanding the value of high-yield bonds

Investors might be forgiven for thinking that the financial world revolves around equities or, increasingly, Bitcoin, but in truth, the world’s bond markets are immeasurably larger and, for the first time in many years, exciting. As we come to the end of the first quarter of 2025, some bonds, especially those issued by corporations, have been having a good run lately.

This should not come as a surprise, as bonds tend to do well in an environment where interest rates are coming down, a prospect that is certainly relevant to UK investors. Recently, Andrew Bailey, the governor of the Bank of England, confirmed to the Financial Times that around four more interest rate cuts were likely in the current interest rate cycle. The possibility of further interest rate cuts may prove positive for corporate bonds in the UK. 

With interest rates expected to decline and yields surpassing 6%, one particular category of corporate bonds - high yield bonds - presents an appealing option for income, diversification, and potential growth. Although risks such as inflation and defaults persist, active fund management can help mitigate these challenges and seize opportunities

Comparing high-yield bonds and gilts

High-yield bonds are investments in corporations with lower credit ratings, which means they carry higher risk. To compensate for this increased risk, these bonds typically offer higher coupon payments. These yields compare favourably with UK government securities, known as gilts, where yields are currently around 4.2% for 2-year maturities and 4.5% for 10-year maturities. As figure 1 shows, yields of six percent or more have been consistent in the high-yield corporate bond space for the last few years.

Understanding corporate bonds

Corporate bonds are loans made to corporations in the US, the UK, and beyond, typically structured as bonds. This asset class is often referred to as corporate credit. Issuers—entities issuing such bonds range from those deemed, by independent ratings agencies, to have a lower risk of not paying the borrowing back classified as ‘investment-grade’ bonds, to higher-risk issuers. These higher-risk bonds, traditionally called ‘junk’ bonds, are more commonly known as high-yield bonds. Higher risk issuers must offer higher interest rates to compensate for the increased likelihood of default compared to investment-grade issuers.

In terms of ratings, the company must be rated at 'BBB' or higher by rating agency Standard and Poor's or 'BAA’ or higher by Moody's to be considered investment-grade, with most government bonds boasting multiple ‘A’ ratings. By contrast, anything rated below those ratings falls into the high-yield category, which includes bonds rated as low as C or CC. Crucially, the high-yield credit market is huge – the global market for these bonds is more than $2000 billion or $2 trillion.

Risks of high-yield bonds

One obvious reason for buying high-yield bonds is that they provide a higher income yield, currently over 6%. Even in the years between 2012 and 2021, when investors navigated a yield-starved investment landscape, the average coupon on global high-yield was 6.4%. That’s 3.8% higher than global investment grade and 5% higher than gilts.

Of course, there are some not insubstantial risks associated with high-yield bonds, not least that investors might find defaults rising as an economy slows down. According to Insight Investment, the typical investor tends to view the historic high-yield default rate as running at between 4% and 5% per annum, thus justifying much higher bond yields. Another obvious risk to watch out for is inflation. If inflation rates shoot up again (and shock the market), we might expect most, though not all, corporate bonds to fall in value as investors adjust their expectations for future returns and government bond yields start increasing again.

Nevertheless, despite these risks, the macroeconomic environment looks potentially appealing. Interest rates may continue falling, if only because UK inflation rates have fallen sharply (though they have taken a recent uptick). Defaults may start rising if there is a recession, but in that situation, the likelihood of interest rate cuts will grow.