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High-yield bonds— What you need to know

High-yield bonds, also referred Key risks credit worthiness based on to as “junk bonds,” are debt High-yield bonds are rated below the predictability of revenues. securities issued by companies BBB- or Baa3 (see Chart 1). As Typically, high-yield issuers operate deemed too risky to be assigned an you progress down the rating in industries where cash flows investment grade credit rating by scale, liquidity can decrease may be highly cyclical, are subject any of the major rating agencies: while default risk, price volatility to fluctuations in commodity Standard & Poor’s (S&P), Moody’s and yield typically increase. prices, or operate in industries and Fitch. The rationale for non- with intense pricing pressures. investment grade ratings includes For example, energy companies an elevated use of leverage, high Background on high yield ratings comprise a significant portion of HY business risk and low earnings • Higher leverage — Leverage indices, and due to their reliance relative to interest payments. measures how much debt capital on oil prices, they can experience a company has on its balance margin pressures when oil prices As a result, investors should view sheet relative to its equity capital. fall, raising the difficulty of making the higher yields available on High-yield issuers typically have interest payments. high-yield bonds as compensation more leverage than investment for the higher level of credit risk grade companies. Greater leverage these securities possess. Chart 1 increases an issuer’s financial risk Just because a bond is rated high- as servicing debt payments could Moody’s S&P Fitch yield by a credit rating agency doesn’t become more difficult if economic/ Aaa AAA AAA necessarily mean the issuer will business conditions deteriorate Aa1 AA+ AA+ default. For example, some issuers and cash flow generation falls. Aa2 AA AA view higher levels of leverage as • Interest coverage — Interest INVESTMENT A1 A+ A+ an optimal capital structure. This coverage is expressed as a ratio GRADE leverage could be used to invest in A2 A A that measures the income or the business, finance acquisitions or A3 A- A- cash flow a company generates return capital to equity shareholders. Baa1 BBB+ BBB+ to its interest payments. Because We believe there may be a place for high-yield issuers carry more Baa2 BBB BBB high-yield bonds in certain clients’ debt, they must also make higher Baa3 BBB- BBB- portfolios, despite the higher credit annual interest payments to their Ba1 BB+ BB+ risk. They can provide the benefits lenders (investors). High-yield Ba2 BB BB of portfolio diversification, higher issuers usually have lower interest Ba3 BB- BB- income to investors and the potential coverage ratios, meaning they B1 B+ B+ for price appreciation, in many cases, generate less earnings relative to B2 B B all the while maintaining a senior their required interest payments— HIGH-YIELD position to common stock on a increasing the possibility of an B3 B- B- company’s balance sheet. interest payment default should Caa1 CCC+ CCC+ business conditions suffer. Caa2 CCC CCC • Business risk — In general, the Caa3 CCC- CCC- business in which a company operates can influence its

Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a bank or any bank affiliate, and are subject to investment risks, including possible loss of the principal amount invested. Page 2 of 2 High-yield bonds—What you need to know, continued

When an issuer fails to make an • Capital structure seniority — Where do high-yield bonds fit in interest or principal payment it Although high-yield bonds have your portfolio? is referred to as a default. During historically been correlated to The growth of high-yield bonds as times of economic distress, high- equities, high-yield bondholders a more widely available asset class yield issuers typically default remain senior to equity holders began in the early 1980s. Fixed- at much higher rates than in the event of bankruptcy or income investors have continued investment grade issuers. liquidation—regardless of issuer to increase allocations to high- credit quality. A basic capital yield bonds as rates have moved structure goes in order: senior Benefits for investors progressively lower over the last debt, subordinated debt, preferred • Diversification — For the 30+ years, and high-yield bonds now stock, and common stock. High- represent an estimated 15% of the appropriate risk-oriented yield bonds will fall into either the investor, high yield can provide corporate bond market according to senior or subordinated debt portion the Securities Industry and Financial diversification benefits to of the capital structure. This means their fixed income portfolios. Markets Association (SIFMA). Even that in the event of a bankruptcy or though this asset class can offer Investing in high-yield bonds liquidation, high-yield bond holders may offer exposure to different many benefits, it is important for will be paid before preferred and investors to note that high-yield industries that might otherwise common stock holders. be unavailable through traditional bonds have different risk and return asset classes. In some cases, profiles than other asset classes, companies may not have publicly and they must consider their own traded equity, but investors risk tolerance prior to investing. RBC can gain exposure to these Wealth Management has established businesses through publicly a High-Yield Policy for its financial traded high-yield debt. advisors to address levels of risk for clients. Please consult your financial • Higher income (Chart 2) — advisor to see if high-yield bonds are High-yield issuers must offer an appropriate investment for you. higher interest rates relative to investment grade (IG) bonds in Chart 2 order to compensate investors Historical OAS to Treasury for taking increased risk. On 25 average, high-yield bonds have offered a yield advantage of 4% higher than investment grade 20 bonds since 1987. High-yield bonds typically offer higher coupon rates than investment grade 15 bonds, which can benefit investors by reducing price sensitivity 10 to changes in interest rates.

• Price appreciation — With a risk/ Index Option Adjusted Spread to Treasury return profile more similar to 5 equities, high-yield bonds often have a greater potential for price 0 appreciation than investment

grade bonds. High-yield bonds may 9/17/20029/17/20039/17/20049/17/20059/17/20069/17/20079/17/20089/17/20099/17/20109/17/2011 9/17/20129/17/20139/17/20149/17/20159/17/20169/17/20179/17/20189/17/20199/17/2020 experience an increased market Source: RBC Wealth Management,Recession BarclaysBloomberg IG Index Barclays HY Index price for a variety of reasons, Past performance is no guarantee of future results. including stronger economic It is not possible to invest directly in an index. growth and improved business fundamentals that could lead to credit ratings upgrades.

Non-investment grade rated bonds (high yield bonds) can involve significant credit risk, default risk and price volatility than investment grade rated bonds, and payment of interest and principal is not assured. © 2021 RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. All rights reserved. 21-36-01674_36170 (07/21)