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Junk bond)
High yield debt (non-investment grade or junk bond) is a business term referring to a corporate debt instrument, usually a bond, that has a higher yield (compared to investment grade debt) because of a high perceived credit risk (default risk).
In modern economies, debt is bought and sold in the form of bonds traded in organized markets. The price of a bond is determined by numerous factors, including the interest rate, the term (amount of time before the bond is paid back in full, also known as the time to maturity ) and the degree of risk associated with the underlying assets.
Flows and levels
Issuance of global corporate high yield debt more than doubled in 2003 to nearly $146 billion in deals priced from less than $63 billion in 2002, although this is less than the record of $150 billion in 1998.
Risk
The holder of a high yield bond 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 interest rates. The credit risk of a high yield bond refers to the probability of a default (e.g., debtor unable to meet interest and principal obligations) combined with the probability of not receiving principal and interest in arrears after a default. The risk of a bond is attempted to be categorized by one of three main credit rating agencies (i.e. Standard and Poor's or S&P, Moody's and Fitch) and is expressed by a rating such as 'AAA' (where 'A' is lower risk than 'B' and 'AA' is lower risk than 'A').
Bonds rated below 'BBB' by S&P are considered to be below investment grade and are colloquially referred to as 'junk' bonds. Bonds rated 'BBB' and higher are called investment grade bonds . This lower rating typically implies 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. In some cases this can lead to a dismal cycle in that a company with financial difficulties will have its bond rating lowered, which will make it harder to raise money thereby deepening its financial troubles.
This cycle was one (but not the only) factor that accounts for the sudden collapse of several high profile companies such as Enron and WorldCom, whose bonds were not initially rated junk.
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, this tends to increase the value of investment grade bonds, however a recession increases the possibility of default in junk bonds.
When analyzing the risk of a high-yield bond, it is important to keep in mind that the expected return from a basket of high yield bonds should approximate that of a similarly diversified list of high grade bonds. The primary difference is that low-rated bonds have a higher expected probability of default, which means that a greater proportion of their expected return comes from interest payments, rather than principal. This, in effect, makes them much less sensitive to interest rate swings, allowing a high-risk company to more easily refinance its debt even if interest rates have increased. The analysis of high-yield debt has much in common with equity analysis, because the viability of the company and its future cash flows determine whether it will be able to repay the debt. The value of a company's equity is considered a 'cushion' beneath the debt of the company, as a company with highly valued equity is likely to have the operational and financial ability to repay debt, and can issue more of its stock for additional financing.
Usage
Junk bonds became ubiquitous in the 1980s by investment bankers, such as 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 amortize the debt over time.
Junk bonds are still used to finance capital intensive industries such as telecommunications. Interestingly the bonds of companies such as Enron and Worldcom were not rated as junk -- Enron, because they hid much of their debt in off balance-sheet transactions, and WorldCom, because they understated their operating expenses while inflating capital expenditures -- so that the financial instability of the company was not known to credit rating groups. Default swaps, which are essentially a bet that a given company will go bankrupt, did trade at a premium for Enron -- an irony, given that the Houston company was an early pioneer in trading them.
See also
External links
Last updated: 05-20-2005 09:35:03
