A Primer on High-Yield Bonds

By: Gary Spitz

As its name suggests, a high-yield bond (also known as a junk bond) is a bond that offers high yields in exchange for a higher risk of defaulting (i.e. a greater returns from interest rather than principal).

In the U.S., there are three principal credit rating agencies: S&P, Moody’s, and Fitch Ratings. These companies rate bonds according to the probability of default together with the probability of not receiving interest and principal subsequent to a default (i.e. credit risk).

For example the scale used by S&P and Fitch is: AAA, AA, A, BBB, BB, B, CCC, CC, C, and D (sometimes consisting of sub-categories). Bonds that are rated AAA by S&P are considered “prime, maximum safety”, and most government bonds fall into this category.

A credit rating BBB or higher indicates that the bond is investment grade, while a credit rating lower than BBB indicates that the bond is non-investment grade, or junk (hence the alternative title of high-yield bonds).

Some institutional investors (e.g. pension funds) are prohibited from investing in bonds below a particular grade level.

For companies whose bonds have been rated investment grade, a downgrade to “junk” status can be a difficult situation. Not only will newly issued bonds now require significantly higher interest payments, but the relatively narrow market for junk bond issues can make them higher to sell. A bond with a credit rating that has dropped below investment grade is commonly referred to as a “fallen angel”.

High-yield bonds play an important role in some investment strategies. A common strategy involving high-yield bonds is merger arbitrage. In a merger, an acquirer would issue junk bonds to help finance an acquisition, after which the acquirer would use the acquired target’s cash flow to pay the debt over a period of time.

For many industries, junk bonds are an important source of capital.

Some recommended reading: Beyond Junk Bonds by Glenn Yago and Susan Trimbath. This book is a very comprehensive guide to the high-yield market in general. Includes case studies of actual firms and securities in the industry, as well as comparisons to the private/public equity, and fixed income markets.

Another highly recommended title, written by an authority on distressed debt and bankruptcy, is: Bankruptcy, Credit Risk, and High Yield Junk Bonds by Edward I. Altman. Includes a dedicated section to High Yield “Junk Bonds and Distressed Securities, and articles from other scholarly contributors around the world.

Article Source: http://articleblender.com

Gary Spitz is a principal of Mt. Rushmore Securities LLC, a broker-dealer registered with the SEC and a member of the NASD which provides brokerage services to private investment pools or funds for compensation. He authors the Hedge Fund Consistency Index

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