Back to the Basics: Understanding High Yield Bonds

What are High Yield Bonds?

High yield bonds are corporate bonds issued by companies with lower credit ratings. These ratings suggest a higher risk that the company might not be able to repay its debt. To compensate investors for this risk, these bonds offer higher interest payments – hence the term “high yield.”

How is “High Yield” defined?

Bonds are rated by credit rating agencies based on the issuer’s ability to repay. The three main agencies are Moody’s, Standard & Poor’s (S&P) and Fitch. A bond is considered investment grade if it’s rated BBB- or higher (S&P/Fitch) or Baa3 or higher (Moody’s). Anything below that is classified as high yield.

Why ratings matter: Default risk

Lower-rated issuers have historically shown a higher probability of default – failing to make interest payments or repay the principal. While exact numbers vary by source and period, here’s a rough guide based on long-term averages:

Rating	Average default rate
BB	~0.5–1.5%
B	~2–5%
CCC	~10–30%

Source: S&P

However, not all is lost in a default. Investors often recover a portion of their investment – this is known as the recovery rate. Historically, recovery rates for high yield bonds have averaged around 40%, though this varies widely.

Credit Spreads: The risk premium

The credit spread is the difference between the yield of a high yield bond and a government bond (like a German Bund) of similar maturity. This spread compensates investors for:

• Default risk
• Liquidity risk (high yield bonds are harder to sell quickly)
• Market volatility

For example, if a German 5-year Bund yields 2% and a high yield bond yields 6%, the credit spread is 4 percentage points or, equivalently, 400 basis points (bps for short).

Are High Yield Bonds still worth the risk?

As of mid-2025, credit spreads for euro-denominated high yield bonds remain relatively tight by historical standards: BB-rated bonds are trading around 200 basis points (bps) over government bonds, while B-rated bonds are near 330 bps. These levels are low compared to long-term averages, yet they still should offer a positive risk premium. When viewed against historical default and recovery rates, current spreads appear broadly sufficient to compensate for expected credit losses – though the cushion above that, the so-called excess risk premium, is thinner than in the past.

Source: Refinitiv Datastream, Data as of 11.7.2025

Market structure and demand dynamics

One reason spreads remain compressed is the persistent demand for high-yielding debt, even as the risk-adjusted size of the market – measured by DV01, a metric that captures the market’s aggregate sensitivity to interest rate and credit spread risk – has not meaningfully grown in over a decade.

Development DV01 since 2010 / Source: Refinitiv Datastream, Data as of 11.7.2025

Lessons from past cycles

In the last 15 years, similar spread levels were observed in 2014, 2017, 2019, and 2021. In each case, spreads eventually widened, but the catalysts were macroeconomic shocks – such as China’s slowdown and commodity price collapse (2014–15), Fed tightening (2018), the COVID-19 pandemic (2020), and an inflationary shock and war in Ukraine (2022–23) – rather than any inherent instability in spreads themselves. While today’s tight spreads warrant a degree of caution, history suggests that the higher yields offered by high yield bonds can still compensate for their risk over the long run.

Conclusion

High yield bonds can be a valuable part of a diversified portfolio, offering attractive returns in exchange for higher risk. Understanding how ratings, spreads, and defaults interact helps investors make informed decisions – especially in the current market environment.

 

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