High-yield debt
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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. Furthermore, unlike most bank debt or investment grade bonds, high yield bonds lack "maintenance" covenants (default occurs if financial health of the borrower deteriorates beyond a set point). Instead, they feature "incurrence" covenants (default only occurs if the borrower undertakes a prohibited transaction, like borrowing more money when it lacks sufficient cash flow coverage to pay the interest).[1]
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[edit] Flows and levels
Global issuance 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. Issuance 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 EUR 31 billion of high yield bonds.[2]
[edit] Risk
The holder of any debt 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-" or "AA+".
Bonds rated BBB- and higher are called investment grade bonds. Bonds rated lower than investment grade on their date of issue 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 have a different investor base than investment grade bonds.
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 tends to increase the possibility of default in junk bonds.
[edit] 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 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.
[edit] Market indices
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 (CSHY) and the Merrill Lynch High Yield Master II. The most-cited bellwether index is the Bear Stearns High Yield Index (BSIX).[citation needed] 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.
[edit] Citations
- ^ Peter V. Darrow et al, U.S. High Yield Bond Market: Opportunities for Foreign Issuers (Mayer Brown law firm, 2005)
- ^ Bryant Edwards et al,[1]|High Yield In France] (Latham & Watkins LLP 2006)
