High-yield debt
Encyclopedia
In finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

 that is rated below investment grade. These bonds have a higher risk of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...

 or other adverse credit event
Credit event
A credit event is the financial term used to describe either:* A general default event related to a legal entity's previously agreed financial obligation. In this case, a legal entity fails to meet its obligation on any significant financial transaction...

s, but typically pay higher yields than better quality bonds in order to make them attractive to investors.

Flows and levels

Global issue 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. Issue is disproportionately centered in the United States, although issuers in Europe, Asia and South Africa have recently turned to high-yield debt in connection with refinancing
Refinancing
Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political...

s and acquisitions. In 2006, European companies issued over €31 billion of high-yield bonds. 2010 is set to be a record year for European Junk Bond issuance, with as much as €50bn expected.

Risk

The holder of any debt is subject to interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...

 and credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of 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.

A credit rating agency
Credit rating agency
A Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...

 attempts to describe the risk with a credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...

 such as AAA. In North America
North America
North America is a continent wholly within the Northern Hemisphere and almost wholly within the Western Hemisphere. It is also considered a northern subcontinent of the Americas...

, the five major agencies are Standard and Poor's, Moody's
Moody's
Moody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...

, Fitch Ratings
Fitch Ratings
The Fitch Group is a majority-owned subsidiary of FIMALAC, headquartered in Paris. Fitch Ratings, Fitch Solutions and Algorithmics, are part of the Fitch Group....

, Dominion Bond Rating Service
Dominion Bond Rating Service
DBRS is a credit rating agency headquartered in Toronto, Ontario. Founded in 1976 by its current owner and president, Walter Schroeder, it is the largest rating agency in Canada....

 and A.M. Best
A.M. Best
A.M. Best Company, Inc., headquartered in Oldwick, New Jersey, is a rating agency designated as a Nationally Recognized Statistical Rating Organization by the United States Securities and Exchange Commission....

. 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
Arrears
Arrears is a legal term for the part of a debt that is overdue after missing one or more required payments. The amount of the arrears is the amount accrued from the date on which the first missed payment was due...

. Government bond
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...

s 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 grade bonds. 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 fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...

s 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
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...

. For example, in a recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

 interest 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.

Corporate debt

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".

The investment banker Michael Milken
Michael Milken
Michael Robert Milken is an American business magnate, financier, and philanthropist noted for his role in the development of the market for high-yield bonds during the 1970s and 1980s, for his 1990 guilty plea to felony charges for violating US securities laws, and for his funding of medical...

 realized 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
Drexel Burnham Lambert
Drexel Burnham Lambert was a major Wall Street investment banking firm, which first rose to prominence and then was forced into bankruptcy in February 1990 by its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken. At its height, it was the...

, followed by those of competing firms, begin organizing 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
Mergers and acquisitions
Mergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...

. In a leveraged buyout
Leveraged buyout
A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...

 (LBO) an acquirer would issue speculative grade bonds to help pay for an acquisition and then use the target's cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...

 to 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.

In emerging markets, such as China and Vietnam, bonds have become increasingly important as term financing options, since access to traditional bank credits has always been proved to be limited, especially if borrowers are non-state corporates. The corporate bond market has been developing in line with the general trend of capital market, and equity market in particular.

Debt repackaging and subprime crisis

High-yield bonds can also be repackaged into collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...

s (CDO), thereby raising the credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...

 of the senior tranche
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...

s 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
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...

, 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 such as Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...

 and other financial institutions during the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

 of 2007-09 and led the US Treasury to seek congressional appropriations to buy those assets in September 2008 to prevent a systemic crisis of the banks.

Such assets represent a serious problem for purchasers because of their complexity. Having been repackaged maybe several times, it is difficult and time-consuming for auditors and accountant
Accountant
An accountant is a practitioner of accountancy or accounting , which is the measurement, disclosure or provision of assurance about financial information that helps managers, investors, tax authorities and others make decisions about allocating resources.The Big Four auditors are the largest...

s to determine their true value. As the recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

 of 2008-9 bites, their value is decreasing further as more debtors default, so they represent a rapidly depreciating asset. Even those assets that might have gone up in value in the long-term are now depreciating rapidly, quickly becoming "toxic" for the banks that hold them. Toxic assets, by increasing the variance of banks' assets, can turn otherwise healthy institutions into zombies
Zombie bank
A zombie bank is a financial institution that has an economic net worth less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support...

. Potentially insolvent banks have made too few good loans creating a debt overhang
Debt overhang
Debt overhang is when an organization has existing debt so great that it cannot easily borrow more money, even when that new borrowing is actually a good investment that would more than pay for itself....

 problem. Alternatively, potentially insolvent banks with toxic assets will seek out very risky speculative loans to shift risk onto their depositors and other creditors.

On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a Public-Private Investment Partnership (PPIP) to buy toxic assets from banks' balance sheets. The major stock market indexes in the United States rallied on the day of the announcement rising by over six percent with the shares of bank stocks leading the way. PPIP has two primary programs. The Legacy Loans Program will attempt to buy residential loans from banks' balance sheets. The Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...

 will provide non-recourse loan guarantees for up to 85 percent of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provide the remaining assets. The second program is called the legacy securities program which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program monies, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF). The initial size of the Public Private Investment Partnership is projected to be $500 billion. Nobel Prize winning Economist and former Enron
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...

 advisor Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

 has been very critical of this program arguing the non-recourse loans lead to a hidden subsidy that will be split by asset managers, banks' shareholders and creditors. Banking analyst Meredith Whitney
Meredith Whitney
Meredith Ann Whitney is a banking analyst and frequent contributor to CNBC, Fox Business, and Bloomberg News programs. Based in New York City, Whitney manages her own advisory firm, Meredith Whitney Advisory Group LLC, where she produces company-specific equity research on financial institutions...

 argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs. Removing toxic assets would also reduce the volatility of banks' stock prices. Because stock is akin to a call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...

 on a firm's assets, this lost volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

 will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices.

High-yield bond indices

High-yield bond indices
Bond market index
A bond market index is a composite listing of bonds or fixed income instruments and a statistic reflecting the composite value of its components...

 exist for dedicated investors in the market. Indices for the broad high-yield market include the CSFB High Yield II Index (CSHY), Citigroup US High-Yield Market Index, the Merrill Lynch High Yield Master II
Merrill Lynch High Yield Master II
The Merrill Lynch US High Yield Master II Index is a commonly used benchmark index for high yield corporate bonds. It is administered by Merrill Lynch. The Master II is a measure of the broad high yield market, unlike the Merrill Lynch BB/B Index, which excludes lower-rated securities.-History:The...

 (H0A0), the Barclays High Yield Index, 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 as the Merrill Lynch Global High Yield BB-B Rated Index (HW40). Other investors focus on the lowest quality debt rated CCC or Distressed securities
Distressed securities
Distressed securities are securities of companies or government entities that are either already in default, under bankruptcy protection, or in distress and heading toward such a condition. The most common distressed securities are bonds and bank debt...

, commonly defined as those yielding 1500 basis point
Basis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...

s over equivalent government bonds.

2010 European sovereign debt crisis

On 27 April 2010, the Greek debt rating was decreased to "junk" status by Standard & Poor's
Standard & Poor's
Standard & Poor's is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock-market indices, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian...

 amidst fears of default by the Greek Government. They also cut Portugal's credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...

s by two notches to A, over concerns about Portugal
Portugal
Portugal , officially the Portuguese Republic is a country situated in southwestern Europe on the Iberian Peninsula. Portugal is the westernmost country of Europe, and is bordered by the Atlantic Ocean to the West and South and by Spain to the North and East. The Atlantic archipelagos of the...

's state debt and public finance
Public finance
Public finance is the revenue and expenditure of public authoritiesThe purview of public finance is considered to be threefold: governmental effects on efficient allocation of resources, distribution of income, and macroeconomic stabilization.-Overview:The proper role of government provides a...

s on 28 April.
On 5 July 2011, Portugal's rating was was decreased to "junk" status by Moody's
Moody's
Moody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...

 (by four notches from from Baa1 to Ba2) saying there was a growing risk the country would need a second bail-out before it was ready to borrow money from financial markets again, and private lenders might have to contribute.

See also

  • Bond market index
    Bond market index
    A bond market index is a composite listing of bonds or fixed income instruments and a statistic reflecting the composite value of its components...

  • Distressed securities
    Distressed securities
    Distressed securities are securities of companies or government entities that are either already in default, under bankruptcy protection, or in distress and heading toward such a condition. The most common distressed securities are bonds and bank debt...

  • Martin S. Fridson
  • Mezzanine capital
    Mezzanine capital
    Mezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares...

  • Merrill Lynch High Yield Master II
    Merrill Lynch High Yield Master II
    The Merrill Lynch US High Yield Master II Index is a commonly used benchmark index for high yield corporate bonds. It is administered by Merrill Lynch. The Master II is a measure of the broad high yield market, unlike the Merrill Lynch BB/B Index, which excludes lower-rated securities.-History:The...

  • Michael Milken
    Michael Milken
    Michael Robert Milken is an American business magnate, financier, and philanthropist noted for his role in the development of the market for high-yield bonds during the 1970s and 1980s, for his 1990 guilty plea to felony charges for violating US securities laws, and for his funding of medical...

  • Thomson Financial League Tables

External links

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