- High-yield debt
finance, a high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated below investment gradeat 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.
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 €31 billion of high yield bonds. [cite paper | last=Edwards | first=Bryant | author= | authorlink= | coauthors="et al." | title=High Yield In France | version= | pages= | publisher= | date=2006 | doi= | url=http://www.lw.com/resource/publications/_pdf/pub1715_1.pdf | format= | id= | accessdate= ]
The holder of any debt is subject to
interest rate riskand 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.
credit rating agencyattempts to describe the risk with a credit ratingsuch as AAA. In North America, the five major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Serviceand 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 gradebonds. 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 recessioninterest 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.
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".
investment banker Michael Milkenrealised 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 flowto 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.Fact|date=March 2008
Debt repackaging and subprime crisis
High-yield bonds can also be repackaged into
collateralized debt obligations (CDO), thereby raising the credit ratingof 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 and other financial institutions during the subprime mortgage crisisof 2007-08 and led the US Treasury to offer to buy those assets in September 2008 to prevent a systemic crisis.
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.
Bond market index
Thomson Financial League Tables
Martin S. Fridson
* [http://www.investopedia.com/articles/02/052202.asp Junk Bonds: Everything You Need to Know]
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