High-yield debt

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(Redirected from Junk bonds)

High yield debt (non-investment grade or junk bond) is a business term referring to a corporate debt instrument, usually a bond, that has a higher yield (compared to investment grade debt) because of a high perceived credit risk (default risk).

In modern economies, debt is bought and sold in the form of bonds traded in organized markets. The price of a bond is determined by numerous factors, including the interest rate, the term (amount of time before the bond is paid back in full, also known as the time to maturity) and the degree of risk associated with the underlying assets.

Contents

Flows and levels

Issuance of global corporate high yield debt more than doubled in 2003 to nearly $146 billion in deals priced from less than $63 billion in 2002, although this is less than the record of $150 billion in 1998.

Risk

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 Standard and Poor's or S&P; Moody's; and Fitch. 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. US Treasury securities 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.

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 a high-risk company 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.

Usage

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 amortize the debt over time.

Junk bonds are still used to finance capital intensive industries such as telecommunications. 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. 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.

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