What are High Yield Bonds?
High Yield Bonds, or “junk bonds”, are corporate debt issuances with sub-investment grade credit ratings. Generally, high yield bonds (HYBs) are unsecured debt instruments with greater upside in potential returns, fixed interest rates, and limited covenants.
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Characteristics of High Yield Bonds (HYBs)
Bond investors effectively provide capital to the issuer of the bond in exchange for the contractual obligation for the issuer to pay periodic interest and repay the original principal once the date of maturity arrives.
Credit rating agencies such as S&P Global, Moody’s, and Fitch publish independent scoring reports to offer guidance to the public on the perceived default risk attributable to specific borrowers.
In particular, a credit rating attempts to determine the appropriate interest rate for lenders to charge, given the risk profile of the borrower.
Each corporate issuer is evaluated on the basis of its capability to fulfill the periodic interest and principal repayment at maturity requirements.
Corporate issuers deemed to carry a greater risk of defaulting are rated “below investment grade,” i.e. the debt securities that fall short in qualifying as an investment-grade rating are referred to as high-yield bonds (HYBs).
- S&P Global Ratings → Lower than BBB
- Moody’s → Lower than Baa3
- Fitch → Lower than BBB-
Since the issuers of high-yield bonds (HYBs) carry greater default risk – as implied by their sub-investment-grade credit ratings – the investors of such issues require higher interest rates to compensate for the higher risk associated with the borrowing.
The investor(s) understand that the risk of not receiving their interest payments and the original principal is greater when dealing with corporates of lower credit quality, hence require a higher yield.
In the event of default, the claims of unsecured, high-yield bonds are of lower priority relative to the claims of secured, senior debt holders.
High Yield Financing in M&A
High yield bonds (HYBs) are frequently associated with M&A, where they are commonly used to fund transactions.
For example, most leveraged buyouts (LBOs) are financed using HYBs as a major source of financing, but the exact relative contribution is dependent on the prevailing conditions of the credit market.
Providers of HYBs receive higher coupons to compensate for their risk and since their claims are placed behind those of investment-grade, senior debt securities.
While not always the case, high yield bonds are typically issued by companies after raising the maximum amount of capital from senior debt lenders (e.g. traditional banks), where any leftover financing needed is raised from HYB lenders.
Alternatively, certain corporations might not have access to senior lenders – most often early-stage companies with a limited track record of performance – and must resort to either issuing more equity or high yield bonds.
Risks of High Yield Bond (HYB) Financing
Before purchasing any high-yield bond, either directly or indirectly, it is essential to understand the credit risk profile of the borrower.
The credit risk of a bond estimates the potential loss incurred if the borrower’s financial state were to deteriorate, resulting in a potential default.
The default risk quantifies the probability of the issuer failing to pay interest and repay principal in a timely manner.
The interest rate risk, or market risk, is another subcategory to consider and represents the chance of movements in interest rates negatively affecting bond investments.
Interest rates and bond prices are inversely related. If interest rates rise, bond prices should decline (and vice versa), with long-term maturities seeing greater fluctuations in pricing.
Compared to investment grade bonds, high yield bonds (HYBs) tend to exhibit more volatility, which stems from the higher default risk found among the underlying issuers and the longer borrowing terms.
In times of economic contractions – i.e. wherein the total number of corporate defaults (and demand for restructuring) spikes – the HYB asset class is less stable relative to the investment-grade debt and fixed-income market.
Types of High Yield Bond Structures
There are various types of high-yield bond issuances that have emerged over time:
- PIK Bonds → The paid-in-kind (PIK) bond is an HYB variation that offers the issuer the option to accrue interest to the principal as opposed to paying it in cash during the period due.
- Step-Ups → Step-up bonds (or “step-ups”) are debt instruments where the coupon payments gradually increase across the bond’s borrowing term in accordance with a predetermined schedule.
- Zero-Coupon Bonds → Zero-coupon bonds, or “zeros”, are issued at a steep discount from the stated face value and pay no interest to the bondholder. Rather, the source of the return is the difference between the 1) face value of the bond and 2) the initial purchase price.
- Convertible Bonds → Convertible high yield bonds are a form of mezzanine financing and are negotiated with terms that can provide the holder with the right to convert the bonds into shares of common stock per agreed-upon terms.
- Tax-Exempt Bond → If governments, municipalities, or related agencies with lower credit ratings issue bonds, these often come with the added benefit of being tax-exempt.
Fundamentals of High Yield Bond Investing – Pros/Cons
The most active HYB market participants are the following:
- Mutual Funds / ETFs
- Institutional Investors, e.g. Hedge Funds
- Insurance Companies
- Pension Funds
- Individual Investors (Indirect)
Below are some incentives for investors to purchase these securities in spite of the risks.
- Upside Potential → Most notably, the reason for investing in these securities is the potential to receive greater income from the interest rate payments if all obligations are met. In addition, the investor could benefit from capital appreciation if the HYB is structured with convertible features.
- Priority of Claims Over Equity → While senior debt claims are placed higher in terms of priority (and have higher recovery rates in the event of default), HYBs still hold priority above all equity stakeholders.
- Portfolio Diversification → HYBs represent a distinct asset class that blends features of traditional debt securities with that of equity instruments, which can prevent over-concentration in one asset class.
- Flexibility of Terms → Compared to other debt securities, HYBs are unique in the sense that most are financing arrangements negotiated to meet the specific needs of the issuer and the investor(s).