High-yield bonds. Bonds that potentially reward investors for taking additional risk. High-yield bond basics

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1 High-yield bonds Bonds that potentially reward investors for taking additional risk Types of high-yield bonds Types of high-yield bonds include: Cash-pay bonds. Known as plain vanilla bonds, these bonds offer investors a fixed coupon rate of interest paid in cash until maturity or an earlier stated redemption date. Split-coupon bonds. With these bonds, the holder generally receives little or no interest during the first few years of the life of the bond. Then the bond steps up to pay a higher coupon (interest rate) until maturity. Most of these bonds are callable at a premium on the step-up date. Zero-coupon bonds. Zeros are sold at a deep discount to their face value and pay no current interest to the bondholders. Instead, the interest is compounded and is paid with the principal at maturity. Convertible bonds. These bonds may be converted into shares of another security (normally the issuing company s common stock) under stated terms. Pay-in-kind bonds. A pay-in-kind bond gives the issuer the option of paying the bondholder interest either in additional securities or in cash. This structure is not common in the marketplace. A high-yield bond, also known as a junk bond, is issued by an organization that does not qualify for an investment-grade credit rating. The lower ratings assigned to high-yield bonds normally translate into higher interest rates to compensate investors for carrying additional risk. High-yield bond buyers include individual investors, high-yield mutual funds, insurance companies and pension funds A balanced, diversified portfolio should include both equity and fixed-income investments. Depending on your risk tolerance, there may be a place in your investment strategy for high-yield bonds, but they are not suitable for all investors. This piece will explain the basics of high-yield bonds, potential benefits for your portfolio, risks, ways to help manage those risks and the tax implications of high-yield bonds. High-yield bond basics A bond is a debt security (an obligation) issued by a company or agency to raise funds for various purposes. When you buy a bond, you are lending the principal amount to the issuer. Depending on the type of bond, you receive interest income for the term of the bond, unless the bond is redeemed, or called, by the issuer before maturity. What is a high-yield bond? High-yield bonds are issued by many different types of U.S. corporations, certain U.S. banks, municipalities, various foreign governments and a few foreign corporations. These organizations cannot meet the standards of investment grade status according to an independent bond-rating agency. Who issues high-yield bonds? The high-yield bond market has existed since the 1970s and has grown dramatically. In the 1980s high-yield bonds often financed speculative takeovers or mergers. While bonds are still issued for this purpose today, bonds are more commonly issued to raise capital. High-yield bonds are issued by: Growing companies. High-yield bonds help finance internal expansion, acquisitions, company start-ups or refinancing of existing debt or to raise funds to fend off a takeover. Emerging or start-up companies in several sectors. Companies in manufacturing, communications, broadcasting, paper and forest products, metals, chemicals, retailers, and homebuilders use high-yield bonds to raise capital. 1 of 8

2 Former investment-grade issuers. High-yield debt is occasionally issued by companies that have fallen on hard times. Companies that carry above-average levels of debt or have intensive needs for capital. Companies involved in leveraged buyouts. Proceeds from high-yield debt can be used to buy a corporation from its shareholders. Foreign governments or corporations. Who buys high-yield bonds? Buyers of high-yield bonds include individual investors, high-yield mutual funds, insurance companies and pension funds, among others. Individual investors. Individuals purchase high-yield bonds directly or through high-yield mutual funds. High-yield mutual funds. Some equity and bond mutual funds purchase high-yield bonds in an attempt to enhance the performance of an aggressive portfolio. Hedge funds. Some hedge funds also purchase high-yield bonds to attempt to enhance the performance of an aggressive portfolio. Hedge funds are complex investment vehicles and are not suitable for all investors. Insurance companies. High-yield bonds are typically used by insurance companies for their own investment needs or to fund the separate accounts of variable insurance and annuity products. Pension funds. In some cases, the rules on the investments of pension funds have been relaxed, allowing pension funds access to the high-yield bond marketplace. 2 of 8

3 Credit rating Credit Risks Investment-grade ratings Highest possible credit rating; principal and interest payments considered very secure. High quality, differs from highest rating only in the degree of protection offered to bondholder. Good ability to pay interest and principal; more susceptible to adverse effects due to changing conditions. Adequate ability to make principal and interest payments; adverse conditions are more likely to affect ability to service debt. Speculative ratings Issuer faces ongoing uncertainties or exposure to adverse business or economic conditions. Greater vulnerability to default but currently meeting debt service requirements. Current identifiable risks of default; in some cases, bonds may already be in default. Moody s Standard & Poor s Fitch Duff & Phelps Aaa AAA AAA AAA Aa AA AA AA A A A A Baa BBB BBB BBB Ba BB BB BB B B B B Caa CCC CCC CCC Most speculative. Ca CC CC CC No interest being paid or bankruptcy petition filed. C D C C Bonds in default. D D D D How can ratings be used to assess risk in high-yield bonds? Investors must pay close attention to the rating of fixed-income investments to help evaluate risk. Moody s Investors Service and Standard & Poor s Corp. are the leading rating agencies for fixed-income securities. In addition, Fitch IBCA and Duff & Phelps rate many bonds. These rating services assess the ability and willingness of issuers to pay interest and repay principal when due. The table above defines the credit ratings assigned to corporate bonds. Corporate bonds rated Baa/BBB or higher are considered investment grade. Corporate bonds rated below this level are considered to be high-yield bonds suitable only for speculative investors willing to accept a greater degree of risk in exchange for a possibly higher return. 3 of 8

4 What other factors should individual investors of high-yield bonds consider? Investors who participate in the high-yield bond market include individuals who invest in high-yield bonds through direct ownership and/or through mutual funds, as well as insurance companies, pension funds and other institutions. Because of the volatile nature of high-yield bonds, individuals should carefully consider the suitability of high-yield bond investments. Suitability. High-yield bonds are not suitable for all investors. You should evaluate your individual financial condition and your ability to tolerate risk before you invest in high-yield bonds. Wells Fargo Advisors does not recommend the purchase of single high-yield issues for clients with a conservative risk tolerance. As an alternative, conservative investors could consider the purchase of a high-yield bond mutual fund. In addition, Wells Fargo Advisors recommends that clients with a moderate to aggressive risk tolerance invest no more than 5% of their total investment portfolio in a single high-yield bond. Diversification. It is recommended that investors observe an asset-allocation strategy and not overweight their overall portfolio in any one class of securities, especially high-yield bonds. Although asset allocation can be an effective investment strategy, it cannot eliminate the risk of fluctuating prices and uncertain returns. Potential benefits For investors who find that the risk profile of high-yield bonds fits their investment objectives, benefits include: Potentially higher income. High-yield bonds offer potentially higher income than more conservative fixed-income investments. The yield spread between highyield bonds and investment-grade bonds is typically between two and four percentage points, depending on the issuer and current market conditions. These higher yields come with an increased risk of default, so investors should be cautious and buy high-yield bonds for only a percentage of their portfolios. Potential for capital appreciation. Bond values can rise because of credit improvement, a rating upgrade, a takeover by a higher-rated company or declining interest rates. Seniority/priority of claims. Bondholders usually have priority over stockholders in a company s capital structure, so they are more likely to receive payment in the event of bankruptcy. The percentage of this payment compared with the original investment is called the recovery rate. The holders of secured debt and unsecured senior debt have the first claims on corporate assets in a bankruptcy distribution. The claims of lower-rated bondholders come before those of either preferred or common stockholders. Claims are met in this order: Secured debt holders Unsecured senior debt holders Other unsecured subordinated debt holders Preferred stockholders Common stockholders 4 of 8

5 Portfolio risk diversification. High-yield bonds are often considered a separate asset class involving different characteristics than other securities. High-yield bonds can help you spread assets across different segments of the financial market, potentially reducing your portfolio s concentration in any one asset class. Flexibility. You can choose a specific sector or company you prefer to invest in, depending on your individual investment objectives and risk tolerance. Exchange listing. Some bonds are listed on the New York Stock Exchange or the American Stock Exchange. Some investors prefer listed bonds for added liquidity and the ability to track the bonds daily trading movements. Risk factors Investors need to understand the risks associated with high-yield bonds. As with any investment, your Financial Advisor can advise you on whether high-yield bonds fit into your overall investment objectives. Credit risk. The potential for loss resulting from an actual or perceived deterioration in the financial health of the issuing company. Two subcategories of credit risk are default risk and downgrade risk: Default risk. The risk that an issuer will be unable to pay interest or principal when due. The risk of default is greater for a high-yield bond than for an investment-grade bond. Many factors can contribute to a default, such as downturns in the economy or a particular industry and threats of competitive takeovers. Liquidity for bonds in default is unpredictable. Downgrade risk. The risk that the independent rating agencies will lower their ratings on a particular bond. A company s rating, for example, could be downgraded from BB to B if the rating agency believes the issuer has become less able to meet its debt obligations. A downgrade is normally accompanied by a decline in the prices of the bonds. When the marketplace anticipates a downgrade, the price often declines before the actual downgrade. Often the rating agencies will place an issue on credit watch status before a downgrade; this also normally brings a price decline. Market risk. This type of risk affects all investments. When interest rates are moving higher, bond prices will normally fall; when rates are moving lower, bond prices will normally rise. The longer-term the bond, the more prices fluctuate with movements in interest rates. Interest-rate risk. This type of risk affects fixed-income security prices, especially when interest rates rise. Since prices of all market-traded bonds move in the opposite direction of rates, rising rates cause bond prices to decline. Longermaturity bonds are the most vulnerable to interest-rate risk. Call risk. Many high-yield bonds are callable after five years following the issue date at par (generally $1,000) or above. Some bonds are non-callable for the life of the bond. After the non-call period, the issuer has the right (but not the obligation) to call the bond for any reason before its stated maturity. As a practical matter, an issuer will generally decide to call a bond when it can issue a new bond at a lower rate than the existing bond. Investors considering an investment in high-yield bonds 5 of 8

6 should note that under this scenario it is unlikely that they would be able to replace their called bond with one that pays an equivalent interest rate. Liquidity risk. When a bond is liquid, the investor can sell it before maturity through an active network of buyers and sellers. With a high-yield bond, some issues may have decreased liquidity because fewer dealers are willing to buy or sell a particular issue at any given time. Normally, the smaller the issuer or the lower the rating, the less liquidity will be available to investors who wish to sell a security. Event risk. A change in company management, shifts in the marketplace, new competition or regulations, or any other event that has a broad effect on an entire industry can affect the ability of bond issuers to pay interest and principal when due. Economic risk. This type of risk is a bond s vulnerability to downturns in the U.S. economy. For example, in 1990 the GDP went into a decline that lasted for three quarters. The principal value and total return of all high-yield bonds declined significantly during that period, leading to an increased default rate. During economic downturns, many investors get nervous and begin a flight to quality, which means selling lower-rated bonds or equities in order to buy much higherrated debt, such as U.S. Treasury bonds or investment-grade corporate bonds. Managing risk High-yield bond investors require a tolerance for risk along with the patience to weather periodic market downturns or unexpected events that negatively affect individual issues. In addition to risk tolerance, investors need access to information or professional guidance in selecting and monitoring specific issues. Some techniques for reducing the special risks of this market are: Diversification. You should consider spreading investments among several issuers and industries to help manage the risk of price declines or defaults caused by industry-specific situations/circumstances. Portfolio adjustments. Another strategy, for example, might involve selling bonds from an industry facing an economic downturn and buying bonds in an industry with a more positive outlook. Credit ratings and research monitoring. Along with the guidance of your Financial Advisor, you could follow the publications of the rating agencies to determine whether a bond has been downgraded or is on credit watch. In addition, a thorough credit analysis of an individual issuer should cover: Financial strength of the company, past and present The strength of the industry sector and the issuer s relative strength or weakness in that sector Evaluation of company management past, present and expected The company s access to capital Protective covenants and features of the specific bond: amount of debt outstanding, liquidity, maturity, call features, credit-agency ratings, current price, yield to maturity and yield to call 6 of 8

7 Company and industry news monitoring. Just as you would follow stocks, you should follow an industry or an issuer to help anticipate factors that may affect the credit rating or the price of a bond. Taxation As corporate debt instruments, high-yield bonds are subject to the same tax treatment for individuals as investment-grade corporate bonds, as described below. Keep in mind that Wells Fargo Advisors is not a tax or legal advisor. For advice about your specific situation, consult your personal tax advisor. Interest. The interest you receive from corporate bonds is subject to federal and state income tax. Like wages, this interest is taxed as ordinary income. Gains and losses. You may generate capital gains on a corporate bond if you sell it at a profit before it matures. If you sell it up to a year from purchase, the gains are taxed at your ordinary rate. If you sell it more than a year after purchase, your capital gains are considered long-term and are currently taxed at a maximum rate of 15%. On the other hand, if you sell a bond for less than you paid, you may incur a capital loss. You may offset an unlimited amount of such losses dollar-for-dollar against capital gains you have realized on other investments (bonds, stocks, mutual funds, real estate, etc.). If your losses exceed your gains, you may currently deduct up to $3,000 of net capital losses annually from your ordinary income. Any capital losses in excess of $3,000 can be carried forward and used in future years. Zero-coupon high-yield bonds. Zeros are relatively rare in the high-yield market, although there are many zero/step-up bonds (bonds whose interest rates are stepped up over time). Zero-coupon bonds pay no current interest. Instead, they pay all accrued interest at maturity. Zero-coupon bonds are issued at prices well below par (maturity) value. A similar type of bond, known as an original-issue discount bond, is issued below par and may pay out some interest. The federal tax treatment of zero-coupon and original-issue-discount bonds is quite complicated, so investors should first consult a tax advisor. Holders of these bonds must pay tax each year on a portion of the discount, even if no interest income is received. Tax-exempt high-yield bonds. When lower-rated governments, municipalities and municipal agencies issue bonds, these are considered high-yield municipal bonds. Their interest may be exempt from federal income tax and from state and local income tax for residents of the state of issue. Consult a tax advisor for more information on tax-exempt high-yield bonds. Costs High-yield bonds are bought and sold between dealers and investors much like other debt instruments. Dealers trade the securities at a net cost, which includes their own spread, or profit, on the transaction. Upon purchase and sale of a high-yield bond, you will incur a commission as a cost of processing each transaction. The commission covers all costs incurred, including administration, transaction and a sales concession paid to your Financial Advisor. 7 of 8

8 For helping you invest in the most appropriate high-yield bonds, Wells Fargo Advisors and your Financial Advisor are compensated in ways that vary depending on the selected investment. Your Financial Advisor will receive compensation in the form of a commission or markup from most transactions. For most purchases, a Financial Advisor s compensation is based on the dollar amount purchased or sold. In certain fee-based accounts, a Financial Advisor s compensation is based on a percentage of assets in the account rather than on the concession, as mentioned above. The compensation formula that determines the amount of payment to your Financial Advisor is generally the same for all high-yield bonds. To learn more about high-yield bonds, ask your Financial Advisor or visit wellsfargoadvisors.com. For additional investor information: Financial Industry Regulatory Authority finra.org Securities and Exchange Commission sec.gov Securities Industry Association sia.com Glossary Call. A decision of the bond issuer to repurchase the bond from the holder at a specified date and price. Most high-yield bonds are callable after five years following the issue date at a premium to par (par is generally $1,000). Some bonds are non-callable. Credit rating. The evaluation of a company s credit standing as determined by the analysts at a credit rating agency, such as Standard & Poor s. Current yield (CY). The annual interest payment (coupon rate) of a bond divided by the current price of the bond. Default. The failure of a bond issuer to pay interest or principal when due. Investment-grade. Refers to bonds rated AAA to BBB. Junk bonds. A term referring to the below-investment-grade status of high-yield bonds. Liquidity. Ability to buy and sell bonds in an orderly and timely fashion. Maturity. The date when the bondholder will receive the final interest payment and the repayment of principal. Most bonds face value is $1,000. Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company Wells Fargo Advisors, LLC. All rights reserved. E of v1

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