High-Yield bonds are those bonds where the issuer pays higher interest rates because these bonds have lower credit ratings than the investment-grade bonds (a rating that shows that a municipal/corporate bond is at low risk of default).
Since they are unstable, high-yield bonds are also known as junk bonds or speculative-grade bonds. Bonds with a high yield usually mature in seven to ten years. There are, however, exceptions. Junk bonds have a higher likelihood of defaulting.
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Summary
High-Yield Bonds can be classified into two categories:
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There was no significant growth of the non-investment-grade market until the 1970s. The demand for high yield, on the other hand, has exploded since the early 2000s. The sector saw its first boom in the 1980s when businesses began to use High-Yield Bonds as a funding vehicle for mergers and leveraged buyouts. The most popular example is the US$31 billion leveraged buyouts of RJR Nabisco by private equity sponsor Kohlberg Kravis & Roberts in the year 1989.
In the US, the overall corporate (investment grade) bond market is approximately US$8.1 trillion, with high yield bonds comprising 15% of the market. Besides, as per last year figures, in the US, the estimated value of the High-Yield Bond market was US$1.2 trillion. Given the present scenario, with both investors as well as the companies preferring this as their investment option, it does not seem that the growth in the non-investment-grade market will slow down in the foreseeable future.
It is believed that high yield bonds are mostly issued by companies or entities who want to raise money for growth, cash flow purposes, or to refinance the existing loans or debts. Few examples can be – Fallen Angels, leveraged buyouts, insurance companies, mutual funds, pension funds, collateralized debt obligations, Exchange-Traded Funds, etc.
Typically, during an economic slowdown, financially depressed companies issue Bonds to raise money.
Advantages:
Disadvantages:
Zero-Coupon Bonds: Zero Coupon bonds also known as accrual bonds refers to those bonds which offer a deep discount and makes no periodic interest payments. Besides, these bonds are suitable for long-term investment plans.
Step-Up Bonds: A Step-up bond is a type of security that possess a coupon rate that increases with time. Other than other benefits, investors investing in these bonds get the benefit of fixed-income securities. These Bonds are managed by the Securities and Exchange Commission (SEC).
Deferred Interest: Deferred Interest bond refers to the bond that pays the interest as a single payment rather than in monthly or periodic installments. Example can be toggle notes and Zero-coupon bonds. Investors looking for a higher rate of interest can opt for these bonds.
Pay in Kinds of Bonds: Pay in Kinds of Bonds is a debt structure wherein the borrowers are permitted to pay interest with additional debt instead of cash. Pay in Kinds of Bonds offer higher yields, because the risk of default by the issuers of these bonds is also high compared to other bonds.
Equity Linked Bonds: Equity Linked Bond is a type of debt instrument with unfixed payments, where the final payout is based on an equity market benchmark. These securities usually mature within twelve months, pay higher yields, and are primarily issued to raise money.
Extendable Reset Bonds: These are the type of bonds that give the bondholders and the issuers the right to extend the initial maturity of a debt security to a later date. Investors tend to benefit from these bonds when interest rates witness a downfall.
The two constant characteristics of Junk Bonds include – Coupon (the rate of interest which the private entities pay to the bondholder or investor every year) and Maturity -- when the full principal amount of the bond issued is due to investors and indicative of interest payment dates.
Other features include if, where, and at what price the borrower can call a bond, financial performance, disclosure covenants, and even equity warrants. It is to be noted that equity warrants often are attached to those junk bonds which are more vulnerable to risks. In such a situation, each bond carries a specific number of warrants to purchase equity in the company later.
There was no significant growth of the non-investment-grade market until 1970s. The demand for high yield, on the other hand, has exploded since the early 2000s. The sector saw its first boom in the 1980s, when businesses began to use High-Yield Bonds as a funding vehicle for mergers and leveraged buyouts. The most popular example is the US$31 billion leveraged buyouts of RJR Nabisco by private equity sponsor Kohlberg Kravis & Roberts in the year 1989.
In the US, the overall corporate (investment grade) bond market is approximately US$8.1 trillion, with high yield bonds comprising 15% of the market. Besides, as per last year figures, in the US, the estimated value of the High-Yield Bond market was US$ 1.2 trillion. Given the present scenario, with both investors as well as the companies preferring this as their investment option, it does not seem that the growth in the non-investment-grade market will slow down in the foreseeable future.
Rating agencies involved in the credit rating of Junk Bonds
Rating agencies, such as Moody’s, S&P and Fitch, are responsible for providing credit ratings to the bonds based on their vulnerability to risks and quality.