What Are High Yield Bonds?
What separates investment grade and sub-investment grade? The answer is a designated credit rating by the mainstream credit rating agencies – Moody’s, S&P and Fitch. Moody’s is widely accepted to be the gold standard for rating agencies.
The rating agencies will assign scores for corporates based on their probability of default – which is generally formulaic with some qualitative adjustments, using a lot of backwards looking data.
Depending on the industry, a rating agency will look at leverage, company scale, interest coverage and other industry unique factors to ascertain a hypothetical risk of default. Companies that do not pass the investment grade bar are accordingly high yield.
Why Investment Grade Ratings Are Important
Purchasers of investment grade bonds are many – insurers, banks, asset managers (mutual funds), hedge funds (who may lever up to make the interest on investment grade bonds more attractive from an absolute perspective), governments and individual investors. For many of the above market participants, investment grade bonds are just another investment.
However, a very large portion of the investment market has constraints on the debt that they are allowed to invest in. As their mandate may not be to generate absolute returns but to generate acceptable returns while having a maximum threshold of risk (insurers cannot afford to lose policyholder float and banks cannot afford to lose depositor money – simply put, regulators and governments will not allow life insurance not to be paid and for people to not be able to withdraw their money), they will have investment policies where they can only invest in investment grade securities.
As such, there is a very large class of investors that will only buy IG bonds.
History of High Yield or Junk Bonds in the Leveraged Finance Market
Debt is an important part of a company’s plans. Whether for general corporate purposes, growth spending, refinancing existing debt, leveraged buyouts, dividend recapitalizations or whatever other reason, companies will look at the debt options available and choose the one that is most appropriate for them.
Historically, smaller companies and less creditworthy companies (and size or scale is looked at positively from a credit standpoint) have not had easy access to debt capital markets solutions like large, investment grade corporates do.
Companies that wanted to issue debt with these characteristics have accordingly stuck with bank debt (loans from the bank), and given the conservative nature of banks who do not seek to lose money, this comes with onerous maintenance covenants such as Debt/EBITDA remaining below 4x (a leverage covenant) and EBITDA/Interest above 4x (a coverage covenant). Previously, the only sub-investment grade bonds were “fallen angels” – or investment grade bonds where credit quality had deteriorated to the point where they were downgraded.
However, leveraged capital markets in the US have become incredibly deep, allowing these corporates to tap into an investor pool.
High yield bonds jumped into the mainstream during the leveraged buy out boom of the 80’s, when corporate raider private equity firms and fee hungry investment banks created a market for high yield bonds to finance extremely levered acquisitions for cash flow heavy companies. Junk bond issuance exceeded $300 billion in 2017 while over a trillion dollars of high yield paper is outstanding.
Who Issues High Yield Bonds?
Junk bond issuers have higher than normal leverage but are not necessarily bad investments. Moody’s and S&P may label a company as riskier if they take on “shareholder friendly initiatives”.
As it follows, many companies rated below BBB have seen outstanding equity performance – although they are in much more trouble when operations do not turn out well. Sometimes, high yield bond issuers are actually fairly conservative corporates that have not achieved the scale required to get an investment grade rating. These are sometimes pseudo-investment grade corporates that may go down a private placement route to get a lower yield at the expense of more restrictive covenants.
Today, while LBOs, dividend recapitalizations and M&A (the sexy stuff) still take up a reasonable part of HYB issuance, much of it is just refinancing of debt for seasoned high yield issuers – whether approaching their scheduled debt maturities or to take out other items in the capital stack – namely bank debt in order to increase their liquidity and flexibility (and because of pressure from corporate bankers).
Likewise, as a mainstream funding conduit these days, when debt capital markets or leveraged capital markets are attractive, companies will use high yield debt to fund capital expenditures or for general corporate purposes.
So the high yield bond issuer market is very robust – and there is often flexibility in the high yield market that does not exist in the very standardized investment grade market in order to give high yield investors adequate comfort or yield in order to satisfy their mandates. There will be call provisions, put provisions, payment-in-kind interest and about anything else that can make the deal get done.
Who Invests in High Yield Bonds?
You can – as a retail investors – although retail investors make up an extremely small part of the pie.
High yield bonds are attractive for various institutional investors for the very reason that their names imply – they offer a higher yield.
A big part of the market is the CDO (collateralized debt obligation – which would include leveraged loans as well) or CBO (collateralized bond obligations) – securitized products packaged by investment banks for institutional investors where the idea is that the default risk for one bond may be unattractive, but by pooling the risk via a basket of high yield bonds, there will be a much more consistent return. These are, of course, associated with the financial crisis of 2008.
There are plenty of dedicated high yield investors ranging from mutual funds such as PIMCO and IA Clarington. These can be part of a universal bond strategy that involves investment grade bonds, a high yield focus or across the wider credit spectrum.
A newer entrant to the market is high yield ETFs. Although these are ostensibly attractive to the retail investor, credit is a very different ball game to equity – and this means that very weak credits will be purchased in accordance with index weights as opposed to any deep credit analysis.
Pension funds also invest in high yield in order to meet their lofty obligations to pensioners/beneficiaries. With interest rates so low on safer debt securities, some quality credit research can get them much higher returns to meet their mandates.
Insurers and hedge funds round out the investor universe, with strategies that can include long/short and bets on credit spreads.
Why Invest in High Yield Bonds?
Why are high yield bonds an attractive investment vehicle?
Aside from the obvious – being high yield, high yield bonds actually provide strong risk adjusted returns, even compared to equities. This partially comes from certain high yield bonds appreciating when they are purchased at a discount, making returns even more attractive.
High yield bonds have historically had an absolute return that is comparable to stocks, but with far lower volatility (stocks can go to zero very easily while high yield bonds are more senior in the capital stack and generally get some recovery even when things go wrong, but will generally pay a very high yield even when equity markets are not doing so well).
For portfolio managers, high yield bonds have a very low correlation with other asset classes – unlike investment grade bonds who are more interest rate sensitive and equities who move very closely with the markets and the economy, high yield bond performance is very much tied to the individual credit story of the issuer.
This is tied to the lower duration as well. While investment grade bonds have longer maturities and an investor may be saddled with a loss from an interest rate increase, high yield bonds mature fairly quickly (4-10 years) so capital can be redeployed.