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In
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of f ...
, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a
bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
that is rated below
investment grade In investment, the bond credit rating represents the credit worthiness of corporate or government bonds. It is not the same as an individual's credit score. The ratings are published by credit rating agencies and used by investment professional ...
by credit rating agencies. These bonds have a higher risk of default or other adverse
credit event A credit event occurs when a person or organization defaults on a significant transaction. He or she is unable to honor the terms of the contract entered, and the borrower’s ability to pay comes into question. Because the marketplace recognizes s ...
s, but offer higher yields than investment-grade bonds in order to compensate for the increased risk.


Default risk

As indicated by their lower credit ratings, high-yield debt entails more risk to the investor compared to investment grade bonds. Investors require a greater yield to compensate them for investing in the riskier securities. In the case of high-yield bonds, the risk is largely that of default: the possibility that the issuer will be unable to make scheduled interest and principal payments in a timely manner. The default rate in the high-yield sector of the U.S. bond market has averaged about 5% over the long term. During the liquidity crisis of 1989-90, the default rate was in the 5.6% to 7% range. During the pandemic of 2020, default rates rose to just under 9%. A
recession In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
and accompanying weakening of business conditions tends to increase the possibility of default in the high-yield bond sector.


Investors

Institutional investors (such as
pension fund A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or scheme which provides retirement income. Pension funds typically have large amounts of money to invest and are the major investors in listed and priva ...
s,
mutual funds A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV ...
,
banks A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Becaus ...
and
insurance companies Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
) are the largest purchasers of high-yield debt. Individual investors participate in the high-yield sector mainly through mutual funds. Some institutional investors have
by-law A by-law (bye-law, by(e)law, by(e) law), or as it is most commonly known in the United States bylaws, is a set of rules or law established by an organization or community so as to regulate itself, as allowed or provided for by some higher authori ...
s that prohibit investing in bonds which have ratings below a particular level. As a result, the lower-rated securities may have a different institutional investor base than investment-grade bonds. .


U.S. market and indices

U.S. high-yield bonds outstanding as of the first quarter of 2021 are estimated to be about $1.7 trillion, comprising about 16% of the U.S. corporate bond market, which totals $10.7 trillion. New issuances amounted to $435 billion in 2020. Indices for the high-yield market include: * ICE Bank of America US High Yield Total Return Index, * Bloomberg Barclays US Corporate High Yield Total Return Index, * S&P U.S. Issued High Yield Corporate Bond Index, and * FTSE US High-Yield Market Index. 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. Other investors focus on the lowest quality debt rated CCC or distressed securities, commonly defined as those yielding 1500
basis point A basis point (often abbreviated as bp, often pronounced as "bip" or "beep") is one hundredth of 1 percentage point. The related term ''permyriad'' means one hundredth of 1 percent. Changes of interest rates are often stated in basis points. If ...
s over equivalent government 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 Investment banking pertains to certain activities of a financial services company or a corporate division that consist in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated with ...
Michael Milken Michael Robert Milken (born July 4, 1946) is an American financier. He is known for his role in the development of the market for high-yield bonds ("junk bonds"), and his conviction and sentence following a guilty plea on felony charges for vio ...
realized that fallen angels had regularly been valued less than what they were worth. His experience with speculative grade bonds started with his investment in these. In the mid-1980s, Milken and other investment bankers at
Drexel Burnham Lambert Drexel Burnham Lambert was an American multinational investment bank that was forced into bankruptcy in 1990 due to its involvement in illegal activities in the junk bond market, driven by senior executive Michael Milken. At its height, it was ...
created a new type of high-yield debt: bonds that were speculative grade from the start, and were used as a financing tool in leveraged buyouts and hostile takeovers. In a
leveraged buyout A leveraged buyout (LBO) is one company's acquisition of another company using a significant amount of borrowed money ( leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loa ...
(LBO), an acquirer would issue speculative grade bonds to help pay for an acquisition and then use the target's
cash flow A cash flow is a real or virtual movement of money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...
to help pay the debt over time. Companies acquired in this manner were commonly saddled with very high debt loads, hampering their financial flexibility. Debt-to-equity ratios of at least 6 to 1 were common in such transactions. This led to controversy as to the economic and social consequences of transforming firms through the aggressive use of financial leverage. 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 A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).Le ...
s (CDO), thereby raising the
credit rating A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting. ...
of the senior
tranche In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see indenture) ...
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 In finance, subprime lending (also referred to as near-prime, subpar, non-prime, and second-chance lending) is the provision of loans to people in the United States who may have difficulty maintaining the repayment schedule. Historically, subpri ...
loans, and lose
market liquidity In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...
, the bonds and their derivatives become what is referred to as "toxic debt". Holding such "toxic" assets led to the demise of several
investment bank Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing i ...
s such as
Lehman Brothers Lehman Brothers Holdings Inc. ( ) was an American global financial services firm founded in 1847. Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank in the United States (behind Goldman Sachs, Morgan Stanley, ...
and other financial institutions during the
subprime mortgage crisis The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the 2007–2008 global financial crisis. It was triggered by a large decline in US home prices after the col ...
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 perhaps several times, it is difficult and time-consuming for
auditor An auditor is a person or a firm appointed by a company to execute an audit.Practical Auditing, Kul Narsingh Shrestha, 2012, Nabin Prakashan, Nepal To act as an auditor, a person should be certified by the regulatory authority of accounting and a ...
s and
accountant An accountant is a practitioner of accounting or accountancy. Accountants who have demonstrated competency through their professional associations' certification exams are certified to use titles such as Chartered Accountant, Chartered Certifi ...
s to determine their true value. As the
recession In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
of 2008–09 hit, their value decreased further as more debtors defaulted, so they represented a rapidly
depreciating asset In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the a ...
. Even those assets that might have gone up in value in the long-term depreciated rapidly, quickly becoming "toxic" for the banks that held them.
Toxic asset A toxic asset is a financial asset that has fallen in value significantly and for which there is no longer a functioning market. Such assets cannot be sold at a price satisfactory to the holder. Because assets are offset against liabilities and freq ...
s, by increasing the variance of banks' assets, can turn otherwise healthy institutions into
zombies A zombie (Haitian French: , ht, zonbi) is a mythological undead corporeal revenant created through the reanimation of a corpse. Zombies are most commonly found in horror and fantasy genre works. The term comes from Haitian folklore, in wh ...
. Potentially insolvent banks made too few good loans creating a debt overhang problem. Alternatively, potentially insolvent banks with toxic assets sought out very risky speculative loans to shift risk onto their depositors and other creditors. On March 23, 2009, U.S. Treasury Secretary
Timothy Geithner Timothy Franz Geithner (; born August 18, 1961) is a former American central banker who served as the 75th United States Secretary of the Treasury under President Barack Obama from 2009 to 2013. He was the President of the Federal Reserve Bank ...
announced a Public-Private Investment Partnership (PPIP) to buy toxic assets from banks' balance sheets. The major stock market indices 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 The Federal Deposit Insurance Corporation (FDIC) is one of two agencies that supply deposit insurance to depositors in American depository institutions, the other being the National Credit Union Administration, which regulates and insures cr ...
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 The Troubled Asset Relief Program (TARP) is a program of the United States government to purchase toxic assets and equity from financial institutions to strengthen its financial sector that was passed by Congress and signed into law by President ...
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
Paul Krugman Paul Robin Krugman ( ; born February 28, 1953) is an American economist, who is Distinguished Professor of Economics at the Graduate Center of the City University of New York, and a columnist for ''The New York Times''. In 2008, Krugman was t ...
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 Ann Whitney (born November 20, 1969) is an American businesswoman hailed as “The Oracle of Wall Street” by ''Bloomberg''. She is known for successfully forecasting the difficulties of Citigroup and other major banks during the financ ...
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 In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy ...
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.


EU member state debt crisis

On 27 April 2010, the Greek debt rating was decreased to "junk" status by
Standard & Poor's S&P Global Ratings (previously Standard & Poor's and informally known as S&P) is an American credit rating agency (CRA) and a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities. S&P is con ...
amidst fears of default by the
Greek Government Greece is a parliamentary representative democratic republic, where the President of Greece is the head of state and the Prime Minister of Greece is the head of government within a multi-party system. Legislative power is vested in both the go ...
. They also cut
Portugal Portugal, officially the Portuguese Republic ( pt, República Portuguesa, links=yes ), is a country whose mainland is located on the Iberian Peninsula of Southwestern Europe, and whose territory also includes the Atlantic archipelagos of th ...
's
credit rating A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting. ...
s by two notches to A, over concerns about its
state debt A country's gross government debt (also called public debt, or sovereign debt) is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit o ...
and
public finance Public finance is the study of the role of the government in the economy. It is the branch of economics that assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achiev ...
s on 28 April. On 5 July 2011, Portugal's rating was decreased to "junk" status by
Moody's Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Investors Service provides internationa ...
(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. On 13 July 2012, Moody's cut Italy's credit rating two notches, to Baa2 (leaving it just above junk). Moody's warned the country it could be cut further. With the ongoing
deleveraging At the micro-economic level, deleveraging refers to the reduction of the leverage ratio, or the percentage of debt in the balance sheet of a single economic entity, such as a household or a firm. It is the opposite of leveraging, which is the pr ...
process within the European banking system, many European CFOs are still issuing high-yield bonds. As a result, by the end of September 2012, the total amount of annual primary bond issuances stood at . It is assumed that high-yield bonds are still attractive for companies with a stable funding base, although the ratings have declined continuously for most of those bonds.


See also

*
Mezzanine capital In finance, mezzanine capital is any 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. Mezzanine financings can be structured either as debt (typical ...
* Thomson Financial League Tables


References


External links

* {{DEFAULTSORT:High-Yield Debt Bonds (finance) Banking Banking terms United States housing bubble Private equity Credit risk