High-yield debt
In finance, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade. These bonds have a higher risk of default or other adverse credit events, 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 refinancings and acquisitions. In 2006, European companies issued over €31 billion of high-yield bonds.[1] 2010 was a record year for European Junk Bond issuance, with as much as €50bn expected.[2]
Risk
The holder of any debt is subject to interest rate risk and credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, 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 attempts to describe the risk with a credit rating such as AAA. In North America, the five major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and A.M. Best. 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. Government bonds 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 funds 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. For example, in a recession 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.
Usage
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 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, 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. In a leveraged buyout (LBO) an acquirer would issue speculative grade bonds to help pay for an acquisition and then use the target's 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.[citation needed]
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.[3]
Debt repackaging and subprime crisis
High-yield bonds can also be repackaged into collateralized debt obligations (CDO), thereby raising the credit rating of the senior tranches 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, 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 and other financial institutions during the subprime mortgage crisis 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 accountants to determine their true value. As the recession 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.[4] Toxic assets, by increasing the variance of banks' assets, can turn otherwise healthy institutions into zombies. Potentially insolvent banks have made too few good loans creating a debt overhang problem.[5] Alternatively, potentially insolvent banks with toxic assets will seek out very risky speculative loans to shift risk onto their depositors and other creditors.[6]
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.[7] PPIP has two primary programs. The Legacy Loans Program will attempt to buy residential loans from banks' balance sheets. The Federal Deposit Insurance Corporation 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.[8] Nobel Prize winning Economist and former Enron advisor Paul Krugman 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.[9] Banking analyst Meredith Whitney argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs.[10] Removing toxic assets would also reduce the volatility of banks' stock prices. Because stock is akin to a call option on a firm's assets, this lost volatility will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices.[11]
High-yield bond indices
High-yield bond indices 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 (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, commonly defined as those yielding 1500 basis points 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 amidst fears of default by the Greek Government.[12] They also cut Portugal's credit ratings by two notches to A, over concerns about its state debt and public finances on 28 April.[13] On 5 July 2011, Portugal's rating was decreased to "junk" status by Moody's (by four notches 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.[14]
See also
- Bond market index
- Distressed securities
- Martin S. Fridson
- Mezzanine capital
- Merrill Lynch High Yield Master II
- Michael Milken
- Thomson Financial League Tables
References
- ^ Edwards, Bryant (2006). "High Yield In France" (PDF). Latham & Watkins.
{{cite journal}}: Cite journal requires|journal=(help); Unknown parameter|coauthors=ignored (|author=suggested) (help) - ^ http://www.ft.com/cms/s/0/439e8134-fe11-11de-9340-00144feab49a.html
- ^ "Vietnam's corporate bond market, 1990-2010: Some reflections" (PDF). The Journal of Economic Policy and Research, 6(1): 1-47. March 15, 2011. Retrieved November 27, 2010.
- ^ "Marketplace Whiteboard: Toxic assets". Marketplace. Retrieved 2009-03-20.
- ^ "Debt Overhang and Bank Bailouts". SSRN.com. February 2, 2009. Retrieved February 2, 2009.
- ^ "Common (Stock) Sense about Risk-Shifting and Bank Bailouts". SSRN.com. December 29, 2009. Retrieved January 21, 2009.
- ^ Andrews, Edmund L.; Dash, Eric (March 24, 2009). "U.S. Expands Plan to Buy Banks' Troubled Assets". New York Times. Retrieved February 12, 2009.
- ^ "FACT SHEET PUBLIC-PRIVATE INVESTMENT PROGRAM" (PDF). U.S. Treasury. March 23, 2009. Retrieved March 26, 2009.
- ^ Paul Krugman (March 23, 2009). "Geithner plan arithmetic". New York Times. Retrieved March 27, 2009.
- ^ "Meredith Whitney: A Bad Bank Won't Save Banks". businessinsider.com. January 29, 2009. Retrieved March 27, 2009.
- ^ "The Put Problem with Buying Toxic Assets". SSRN.com. February 14, 2009. Retrieved February 15, 2009.
- ^ Greek Debt Rating cut to Junk Status, The New York Times, April 27, 2010
- ^ "Fears grow over Greece shockwaves". BBC News. April 28, 2010. Retrieved May 4, 2010.
- ^ "Portugal's debt is downgraded to junk status by Moody's". BBC News. July 5, 2011. Retrieved July 5, 2011.
