High-yield debt
In
finance, a
high-yield bond (
non-investment grade bond or
junk bond) is a
bond that is rated below
investment grade. These bonds have a higher risk of defaulting, but typically pay high yields in order to make them attractive to investors. These types of bonds are also known as
junk bonds.
Global issuance of high yield bonds more than doubled in 2003 to nearly $146 billion in deals issued from less than $63 billion in 2002, although this is less than the record of $150 billion in 1998. Issuance is largely from
corporate entities, though some below investment grade trenches may be issued by private
mortgage and
ABS issuers. Issuance is disproportionately centered in the
U.S.A., as the reliance on bank loans tends to be greater where securities markets are less developed.
The holder of a high yield bond is subject to
interest rate risk and
credit risk. Interest rate risk refers to the risk of a bond changing in value due to changes in the structure or level of interest rates. The credit risk of a high yield bond refers to the probability of a default (i.e., debtor unable to meet interest and principal obligations) combined with the probability of not receiving principal and interest in arrears after a default. A
credit rating agency attempts to describe the risk with a
credit rating such as AAA. In the
USA, the three major agencies are
S&P,
Moody's and
Fitch Ratings. Bonds in other countries may be rated by US rating agencies or by local agencies like the
Dominion Bond Rating Service (DBRS) in
Canada. Rating scales vary; the most popular scale uses (in order of increasing risk) ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, with the additional rating D for debt already in arrears.
Government bonds are often considered to be in a zero-risk category above AAA; and categories like AA and A may sometimes be split into finer subdivisions like "AA (low)".
Bonds rated BBB and higher are called
investment grade bonds. Bonds rated lower than investment grade are colloquially referred to as "junk" bonds. The lower-rated debt typically offers a higher yield, making junk bonds attractive investment vehicles for certain types of
financial portfolios and strategies. Many
pension funds and other investors, however, are prohibited in their
by-laws from investing in bonds which have ratings below a particular level. As a result, the lower-rated securities may be harder to sell. In some cases the limited market for junk bonds can lead to a dismal cycle in which a company with financial difficulties will have its bond rating lowered, and that makes it harder to raise money, thereby deepening the company's financial troubles.
This cycle was one (but not the only) factor that accounts for the sudden collapse of several high profile companies such as
Enron and
WorldCom, whose bonds were not initially rated junk. Bonds that decline from investment grade status to high yield are referred to as "fallen angels", while high yield bonds with credit metrics that improve may receive investment grade ratings and be referred to as "rising stars." Investors in high yield bonds expect credit quality to typically improve over time, and when the perceived risk of a credit decreases, then the return (interest rate) demanded by investors will also decrease, and the price of the bond will increase (lowering the effective interest rate received by the person who buys the bond at that point). Through this mechanism, investors in high yield bonds may enjoy yields above treasury rates, and then further capital appreciation as the credit quality of a bond improves.
The value of junk bonds is affected to a higher degree than
investment grade bonds by the possibility of
default. For example, in a
recession interest rates tend to drop, and the drop in interest rates tends to increase the value of investment grade bonds; however, a recession increases the possibility of default in junk bonds.
When analyzing the risk of a high-yield bond, it is important to keep in mind that the expected return from a basket of high yield bonds should approximate that of a similarly diversified list of high grade bonds. The low-rated bonds offer higher promised returns but have a higher expected probability of default, which means that a greater proportion of their expected return comes from interest payments rather than principal. As a result, they are less sensitive to interest rate swings, allowing high-risk companies to more easily refinance its debt even if interest rates have increased. The analysis of high-yield debt has much in common with equity analysis, because the viability of the company and its future cash flows determine whether it will be able to repay the debt. The value of a company's equity is considered a cushion beneath the debt of the company, as a company with highly valued equity is likely to have the operational and financial ability to repay debt, and can issue more of its stock for additional financing.
Junk bonds became ubiquitous in the
1980s, through the efforts of investment bankers like
Michael Milken, as a financing mechanism in
mergers and acquisitions. In a
leveraged buyout (
LBO) an acquirer would issue junk bonds to help pay for an acquisition and then use the target's
cash flow to help pay the debt over time.
Junk bonds are still used to finance
capital intensive industries such as
telecommunications and oil and gas sectors. Interestingly the bonds of companies such as Enron and Worldcom were not initially rated as junk — Enron, because they hid much of their debt in
off balance-sheet transactions, and WorldCom, because they understated their operating expenses while inflating capital expenditures — so that the financial instability of the company was not known to
credit rating groups.
Credit default swaps, which are essentially a bet that a given company will go bankrupt, did trade at a premium for Enron — an irony, given that the Houston company was an early pioneer in trading them.
Market indices exist for dedicated investors in the market. The major indices for the broad high yield market include the
CSFB High Yield II Index and the
Merrill Lynch High Yield Master II. The most-cited
bellwether index is the Bear Stearns High Yield Index (BSIX). Some investors, preferring to dedicate themselves to higher-rated and less-risky investments, use an index that only includes BB-rated and B-rated securities, such at the
Merrill Lynch BB/B Index.
*
Thomson Financial League Tables*
Thomson - Financial - League Tables**
4Q03 Global Capital Markets Press Release
