Hi, I’m Jennifer Poon from the T. Rowe Price Fixed Income team, and I want to talk about one of the most important concepts in high yield investing – credit spreads.

High yield bonds, as the name suggests, offer higher yields than government or investment-grade bonds. That’s because you’re taking on a bit more credit risk, and the extra yield – called the credit spread – is your compensation for that risk. 

A credit spread is the extra yield a company has to pay above a government bond to borrow money. So the riskier the company is, the bigger the spread investors demand as compensation for taking on that extra credit risk.

In high yield, the biggest risk is credit risk – specifically the risk of default.

A default occurs when a company doesn’t meet its debt obligations. That could mean missing a coupon payment, failing to repay the principal at maturity, or restructuring its debt in a way that causes losses to bondholders.

In short, the company doesn’t pay what it promised – and those are permanent losses that can drag on returns.

But the good news is that investors are compensated for that risk by the credit spread. And historically, credit spreads – that extra yield – have more than covered actual default losses. So while the risk is real, the market tends to overprice it, which creates opportunities for disciplined investors. 

Defaults do happen in high yield, but they’re not as frequent as many people think. The average default rate in the US high yield market in the last 10 years has been 2.6% per year. The credit spreads over the same period are on average around 4.4%. So that extra yield you earn – has historically been much higher than the actual losses from defaults, leaving a cushion for investors. 

I hope this gives you a clearer picture of what you’re really being compensated for in high yield.

For more information on how high yield can help your portfolio, consider reaching out to your financial adviser.