What it means
Lenders price risk into the interest rate they charge. A borrower with a strong balance sheet and steady cash flow can raise money cheaply, while a heavily indebted or unproven one has to offer a much larger coupon to attract anyone at all.
The dividing line between the two worlds is a credit rating. Debt rated at or above the investment grade threshold by the main agencies counts as investment grade, and anything below it is high yield, a single classification that changes which investors are even permitted to buy.
For a company, issuing high yield debt is often the price of ambition. Buyouts, rapid acquisition programmes and turnarounds are frequently funded this way because conventional bank lending will not stretch to the full amount at ordinary rates.
For an investor, the extra yield is compensation rather than a bonus. The spread over government bonds is meant to cover expected defaults plus a premium for the risk of misjudging them, and in a bad year defaults can comfortably exceed the extra income collected.
The nuance worth carrying into any conversation is how this debt behaves in a downturn. High yield tends to move with the stock market rather than with safe government bonds, so it offers far less protection than the word "bond" might suggest at the moment a portfolio most needs it.
High yield lending also comes with strings attached. Covenants on interest cover, total debt and asset sales are usually tighter than on investment grade debt, and breaching one can hand control of the conversation to lenders long before any payment is actually missed.
In practice
Real-world examples.
Example
A private equity firm funds a $400,000,000 acquisition with $150,000,000 of equity and $250,000,000 of high yield bonds paying 9%. The high coupon is accepted because the debt does not have to be repaid until the business is sold or refinanced.
Example
An income fund manager holds a mix of investment grade and high yield bonds, capping the high yield portion at 20% of the portfolio. The cap exists because those holdings would fall hardest if the economy turned.
Example
A mid-sized retailer downgraded below investment grade after two weak years finds its next bond issue prices at 10% rather than the 5% it paid previously. The extra $5,000,000 of annual interest on a $100,000,000 issue forces the board to shelve two store openings.
Think of it
“High yield means higher risk bonds paying higher rates-more return for accepting more default risk.
Formula
Calculation
Current Yield = Annual Coupon Payment / Current Market Price of the Bond.
Credit Spread = Yield on the Bond - Yield on a Government Bond of the same maturity.
Take a five-year corporate bond with a face value of $1,000 and an 8% coupon, currently trading at $950.
Annual coupon payment = $1,000 multiplied by 8% = $80.
Current yield = $80 / $950 = 0.0842, or 8.42%.
If the equivalent five-year government bond yields 3.40%, then the credit spread = 8.42% - 3.40% = 5.02 percentage points, which the market would describe as roughly 500 basis points over. That spread is the market's price for taking on the risk that this particular borrower does not pay.Case study
Seen in the real world.
Northgate Leisure Holdings is an illustrative, entirely invented operator of gyms and swimming centres. To fund a rapid expansion it issued $180,000,000 of high yield bonds at a 9.5% coupon, well above the 4% its investment grade competitors were paying, because its debt already sat at four times earnings.
For three years the arrangement worked, as new sites opened and earnings rose faster than the interest bill. Then membership growth stalled, and with $17,100,000 of annual interest to find, Northgate had almost no room to cut prices or invest in refurbishment.
In this fictional account the company eventually negotiated with bondholders, who accepted a 25% haircut on their claims in exchange for shares in the restructured group. Existing shareholders were left with a small minority stake, and the founders lost control of a business that had been profitable at the operating level throughout. The illustrative lesson is that a high yield coupon is affordable only for as long as growth outpaces it.
Watch out
Common mistakes.
- Choosing a bond on its headline yield alone, without asking why the market demands such a high return from that particular borrower.
- Assuming all bonds are defensive holdings, when high yield behaves much more like equity during a market fall.
- Comparing a high yield coupon with a savings rate as though the two carry similar safety, when only one of them involves genuine default risk.
Questions
People also ask.
Why are these called junk bonds?
It is an old market nickname for sub-investment grade debt; issuers and fund managers prefer "high yield" but the two mean the same thing.
Do high yield bonds usually default?
Most do not, and long-run default rates are typically a low single-digit percentage each year, though the figure rises sharply in recessions.
Can a company move from high yield back to investment grade?
Yes, and it happens regularly when debt is repaid and earnings recover; such issuers are often called rising stars in the market.
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