High-Yield Bond

A high-yield bond is a corporate bond from a company that might not pay you back. Rating agencies mark it BB+ or lower, which puts it below what they call investment grade. The borrowers are companies carrying a lot of debt, or in industries that swing hard with the economy, or too young to have a record — or ones that used to be safe and no longer are.

You are paid openly for that risk. These bonds yield several percentage points more than safe ones: about 3–5% extra when markets are calm, and more than 10% extra when they are frightened.

The market was more or less invented in the 1980s. Until then, risky bonds were leftovers — bonds from companies that had fallen out of favour after they were issued. Michael Milken's desk at Drexel Burnham turned that backwater into a market where risky companies could borrow on purpose, at scale. That money paid for the takeover boom of the decade and for a generation of telephone and cable networks. It also ended in Drexel being charged and collapsing. The market grew up anyway. The nickname "junk" never went away.

The important thing is how these bonds behave. They pay a coupon like a bond, but in a recession they fall with shares, not with government bonds. That is not a coincidence: a share and a risky bond are both asking the same question, which is whether this company survives. A high-yield fund sits far closer to a cautious share portfolio than to a government bond one, whatever the word "bond" in its name suggests.

The arithmetic of the spread

The spread must cover expected default losses, with the remainder as risk premium:

Long-run HY default rates average ~3–4% a year (peaking above 10% in recessions) with recoveries near 40%: expected loss ≈ 2%. Historical spreads averaged ~4–5% — the difference is why diversified high yield has beaten investment grade over most long windows, and the crises are why it hasn't felt like it.

Structural features that define the market

• Callable, almost always: issuers can refinance after 3–5 years at declining premiums — your upside is capped near the call price, so bonds trade on yield-to-worst, not yield-to-maturity.
• Covenants: HY indentures restrict extra debt, dividends and asset sales — protections IG bonds don't need and HY investors negotiate hard for (and have been losing gradually for a decade; "covenant-quality scores" track the erosion).
• Ratings tiers: BB behaves like almost-IG; single-B is the market's core; CCC is equity in a bond costume, driving most of the index's defaults and most of its recovery-rally upside.
• Fallen angels vs. original issue: bonds demoted from IG have historically outperformed same-rated original-issue HY — forced selling at the downgrade creates the entry price.

Yield-to-worst and negative convexity

With call schedules attached, the bond's value is a min over call scenarios:

Tightening spreads push prices into the call ceiling — upside convexity is sold to the issuer. The consequence: HY total returns are carry-dominated; capital-gain rallies are structurally capped while drawdowns are not. Effective duration is also spread-dependent — as spreads widen, expected calls vanish and duration extends, exactly when you least want it.

Distress mechanics

• The distress boundary: bonds beyond ~1000bp trade on recovery, not yield — price becomes (probability-weighted) expected recovery, and the analysis shifts to capital structure: what's above you, what's the collateral, where does value break.
• Liability management: the modern loosening of covenants enabled "creditor-on-creditor violence" — drop-down financings (J.Crew), uptiering (Serta) — where subsets of holders exchange into senior claims and strand the rest. Reading the docs is now alpha, not diligence.
• Recovery cyclicality: recoveries fall exactly when defaults spike (same recession), so expected loss is convex in the cycle — Moody's data show recovery on senior unsecured dropping from ~45% in calm years to ~25% in crisis years.

The index-liquidity mismatch

HY ETFs offer minute-by-minute liquidity on bonds that trade by appointment. In March 2020 the big ETFs traded at 3–5% discounts to stale NAVs — functioning, as later analysis conceded, as the price-discovery vehicle rather than the anomaly. The Fed's corporate-credit facilities (SMCCF), which bought HY ETFs directly, ratified the structure: the wrapper is now systemically load-bearing.

The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.