High-yield debt
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In finance, a high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated below investment grade at the time of purchase. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors.
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[edit] Flows and levels
Global issue of high yield bonds more than doubled in 2003 to nearly $146 billion in securities issued from less than $63 billion in 2002, although this is still less than the record of $150 billion in 1998. Issue is disproportionately centered in the U.S.A., although issuers in Europe, Asia and South Africa have recently turned to high yield debt in connection with refinancings and acquisitions. In 2006, European companies issued over €31 billion of high yield bonds.[1]
[edit] Risk
The holder of any debt is subject to interest rate risk and credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Interest rate risk refers to the risk of the market value of a bond changing in value due to changes in the structure or level of interest rates or credit spreads or risk premiums. The credit risk of a high yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency including Fitch, Moody's, or Standard & Poors.
A credit rating agency attempts to describe the risk with a credit rating such as AAA. In North America, the five major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and A.M. Best. Bonds in other countries may be rated by US rating agencies or by local credit rating agencies. 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 and bonds issued by government sponsored enterprises (GSE's) 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-" or "AA+".
Bonds rated BBB- and higher are called investment grade bonds. Bonds rated lower than investment grade on their date of issue are called speculative grade bonds, derisively referred to as "junk" bonds.
The lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehicles for certain types of financial portfolios and strategies. Many pension funds and other investors (banks, insurance companies), 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 have a different investor base than investment-grade bonds.
The value of speculative bonds is affected to a higher degree than investment grade bonds by the possibility of default. For example, in a recession interest rates may drop, and the drop in interest rates tends to increase the value of investment grade bonds; however, a recession tends to increase the possibility of default in speculative-grade bonds.
[edit] Usage
[edit] Corporate debt
The original speculative grade bonds were bonds that once had been investment grade at time of issue, but where the credit rating of the issuer had slipped and the possibility of default increased significantly. These bonds are called "Fallen Angels".
The investment banker Michael Milken realised that fallen angels had regularly been valued less than what they were worth. His time with speculative grade bonds started with his investment in these. Only later did he and other investment bankers at Drexel Burnham Lambert, followed by those of competing firms, begin organising the issue of bonds that were speculative grade from the start. Speculative grade bonds thus became ubiquitous in the 1980s as a financing mechanism in mergers and acquisitions. In a leveraged buyout (LBO) an acquirer would issue speculative grade bonds to help pay for an acquisition and then use the target's cash flow to help pay the debt over time.
In 2005, over 80% of the principal amount of high yield debt issued by U.S. companies went toward corporate purposes rather than acquisitions or buyouts.[citation needed]
[edit] Debt repackaging and subprime crisis
High-yield bonds can also be repackaged into collateralized debt obligations (CDO), thereby raising the credit rating of the senior tranches above the rating of the original debt. The senior tranches of high-yield CDOs can thus meet the minimum credit rating requirements of pension funds and other institutional investors despite the significant risk in the original high-yield debt.
When such CDOs are backed by assets of dubious value, such as subprime mortgage loans, and lose market liquidity, the bonds and their derivatives are also referred to as toxic debt. Holding such "toxic" assets has led to the demise of several investment banks such as Lehman Brothers and other financial institutions during the subprime mortgage crisis of 2007-09 and led the US Treasury to buy those assets in September 2008 to prevent a systemic crisis of the banks.
Such assets represent a serious problem for purchasers because of their complexity. Having been repackaged maybe several times, it is difficult and time-consuming for auditors and accountants to determine their true value. As the recession of 2008-9 bites, their value is decreasing further as more debtors default, so they represent a rapidly depreciating asset. Even those assets that might have gone up in value in the long-term are now depreciating rapidly, quickly becoming "toxic" for the banks that hold them.[2] It is said to be one reason why UK banks for example have suffered severe falls in their share prices in January 2009, in many cases, to market values substantially less than their net worth judged by real asset value.
Another effect of the crisis of 2008-9 has been to reveal numerous cases of financial fraud, such as the Bernard Madoff Ponzi scheme.
[edit] High-yield bond indices
High-yield bond indices exist for dedicated investors in the market. Indices for the broad high yield market include the CSFB High Yield II Index (CSHY), the Merrill Lynch High Yield Master II (H0A0), and 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. Other investors focus on the lowest quality debt rated CCC or Distressed securities, commonly defined as those yielding 1000 basis points over equivalent government bonds.
[edit] See also
- Bond market index
- Thomson Financial League Tables
- Distressed securities
- Martin S. Fridson
- Mezzanine capital
[edit] References
- ^ Edwards, Bryant; et al. (2006). High Yield In France. Latham & Watkins. http://www.lw.com/upload/pubContent/_pdf/pub1715_1.pdf.
- ^ "Marketplace Whiteboard: Toxic assets". Marketplace. http://marketplace.publicradio.org/videos/whiteboard/toxic_assets.shtml. Retrieved on 2009-03-20.
[edit] External links
- Junk Bonds: Everything You Need to Know
- High Yield Blog: includes more than 700 credit snapshot reports for free download
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