High Yield Bonds
The international bond market is a large and diverse market. There are various categories of bonds that are issued in these markets globally. However, they can be categorized based on their risk-return profile. The safest bonds are issued by sovereign entities. They are considered to be the safest since governments have the power to tax people and also to print currency, if necessary. Hence, they offer the lowest yields. Bonds issued by blue-chip corporations are next in the hierarchy. They are also considered to be safe and hence the yields are low, even though they are higher than sovereign bonds.
The next type of bonds in the hierarchy are issued by corporations that are not highly rated and may not have a stable cash flow history. These types of bonds have a completely different risk-return profile as compared to bonds issued by sovereign entities. These bonds are called high yield bonds. High-yield bonds form a significant sector of the overall bond market. It is estimated that high-yield bonds account for almost 20% of all bonds in existence. In terms of dollar value, it is extrapolated that the size of the high yield bond market is close to $9 trillion! The humungous size of the high-yield bond markets makes it impossible for investors to ignore this market.
In this article, we will have a closer look at the concept of high yield bonds and how they fit into an investor’s overall portfolio.
What is a High Yield Bond?
The bond market has a standard definition for what can be considered to be a high-yield bond. This definition is based on the credit rating of the issuer which is issued by major credit rating agencies. Credit rating companies study the financials of the firm and rate issuers on the basis of their ability to pay back the interest as well as principal on the loan which they are undertaking. If the rating received by the issuer is below BBB+ or Baa3, then such bonds are considered to be high yield bonds. Basically, these bonds are issued by firms that are considered to be investment grade. However, they still have questionable financials. This is the reason that such companies have to pay a higher yield to attract investors to buy their bonds. Hence, the security has been named as “high yield bonds”.
The size of the high yield bond markets is not fixed. It fluctuates based on the financial condition of the companies issuing bonds. If the rating of more companies falls below investment grade, then the size of the high yield bond market increases. Conversely, if the finances of several companies improve at the same time, then the size of the high yield bond market shrinks.
Who Issues High Yield Bonds?
High-yield bonds are mainly issued by two different types of companies.
- The first type of company is known as fallen angels. These are companies that were earlier considered to be investment-grade corporations. However, due to some reason, their credit rating has taken a hit in recent times. In most cases, these companies have undertaken a leveraged buyout in the recent past. As a result, their balance sheet is laden with debt and hence they are now considered to be risky bets.
- The second type of companies are organizations that were always below investment grade. These companies have questionable finances. However, a lot of the time, they are targets for mergers. Alternatively, they may be companies that have shown an increased potential for economic growth in the recent past. It is for this reason, that such companies are often referred to as rising stars.
Apart from these two types of companies, there are several other types of companies that issue high yield bonds:
- Start-up companies with no investment history are also frequently involved in the issue of high yield bonds
- There are many companies that finance their bankruptcy exit financing by issuing high yield debt in the bond market.
The issuance of high yield bonds is highly correlated to the general state of the economy. When the entire economy is bullish and investors as a whole have a higher risk appetite, the number of high yield bonds being issued increases greatly. The opposite of this is also true and the issuance of high yield bonds drops dramatically when the general market scenario turns negative.
The high yield bond sector is a relatively nascent invention in the overall bond market. They have been popularized by various hedge funds and private equity funds which have been able to generate a much higher return as compared to the overall market by using high yield bonds. Needless to say, high-yield bonds carry significantly higher risks. Hence, these bonds must be purchased by sophisticated investors who have some experience in the bond market. Novice investors are likely to lose money if they invest directly in such bonds.
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