High Yield (Junk) Bonds
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A high-yield bond issue, commonly known as a junk bond, is a bond that currently has a non-investment grade credit quality rating from one or more bond credit rating agencies. Non-investment grade credit ratings are credit ratings of BBB+, or lower.
Who are High-Yield Bond Issuers?
The two major issuers of high-yield bonds are original issuers and so-called fallen angels:
» An original issuer is a bond issuer with a non-investment grade credit rating at the time of underwriting. A non-investment grade is typically assigned to new issue bonds for one or more of the following reasons:
– The issuer is highly leveraged (relative to its immediate competitors or typically for its industry).
– The issuer has no demonstrable operating track record but has above-average growth and profitability prospects. For example, it may be a start-up company in an emerging and potentially profitable industry.
– The issuer is currently experiencing financial difficulties, but does not have any bonds presently outstanding.
» A fallen angel is a bond issuer that once had an investment-grade credit rating on its outstanding bonds, but has recently fallen into financial difficulty. The issuer’s outstanding bonds, as a result, have been downgraded to non-investment status. Fallen angels can be either in or on a path to bankruptcy. Certain institutional investors in high-yield bonds specifically target fallen angels for their potential investment value. They purchase downgraded securities that are in either reorganisation or liquidation, depending whether the issuer is near bankruptcy or in bankruptcy court protection.
High-Yield Bond Investors
Individuals rarely invest directly in high-yield bonds. However, they can gain indirect exposure by investing in managed financial products. Most outstanding high-yield bond issues are held by institutional investors. Because of the inherent credit risk and complexity of high-yield bonds, investors require at least the following two factors to be successful in high-yield bond investing:
» They must conduct proper, detailed fundamental analysis on high-yield bonds and their respective issuers.
» They must diversify their holdings to compensate for the risk associated with individual bond issues.
Credit Spread for High-Yield Bonds
As compensation for assuming credit risk, lenders require incentive to purchase corporate bonds, both at the time of bond underwriting and in secondary market trading, in the form of a higher yield. This so-called credit premium is calculated as the difference between the yield to maturity (YTM) of the corporate bond minus the YTM of a national government bond of the same maturity.
All else being equal, the lower the perceived credit risk of the bond, the higher its credit rating and the smaller (or tighter) the yield spread will be. Primarily because of their inherent higher degree of leverage, the credit spreads of high-yield bonds generally react quickly to credit rating upgrades or downgrades, and to corporate announcements that suggest a change in the issuer’s creditworthiness.
Default Risk and Default Rates
A key metric for estimating default risk in the junk bond market is the default rate over various periods.
Defaults are defined as bond issues where one of the following events has occurred:
» A missed payment of interest or principal due has not been paid within the normal 30-day grace
period.
» The issuer has fi led for bankruptcy protection or liquidation.
» A corporate restructuring has been announced.