High-yield bonds, often called junk bonds, pay a higher interest rate than investment-grade bonds that usually reflects their lower credit rating and their greater risk of default. High-yield bonds that have at least a BB or a B rating are sometimes referred to as speculative-grade bonds that have a businessman's risk. The lower credit rating is usually the result of deteriorating finances, because it's a new business that don't have a track record, or because the company has taken on a large amount of additional debt, such as occurs in a leveraged buyout. However, some subordinated debt of investment-grade issuers may also get a speculative-grade rating, due to the greater credit risk of junior bonds.
Fallen angels, sometimes referred to as special situations, are bonds that were issued with an investment-grade rating, but, because of the deteriorating finances of the company, the bonds were downgraded to a BB rating or less. Many of these companies are near bankruptcy or in default. The key to profiting from fallen angels is to determine the amount that could be recovered in a liquidation or reorganization.
Prior to 1977, almost all junk bonds were fallen angels, because bonds were not issued with less than an investment-grade rating.
Original Issuers of Junk Bonds—Story Bonds
Drexel Burnham Lambert pioneered the marketing of original-issue junk bonds. As junk bond traders, Drexel Burnham Lambert knew there was a market for fallen angels, so why wouldn't there be a market for original-issue junk. Although the issuers of original junk bonds must pay a higher yield than on investment-grade bonds, the yield was still lower than what many businesses had to pay for bank loans, if they could get a bank loan at all. Hence, many of these businesses, sometimes referred to as venture-capital situations, growth market or emerging market companies, were willing to issue original-issue junk bonds. In the hope of lowering the yield, these bonds were often sold with optimistic financial projections and a description of how it would be achieved—hence, the nickname, story bonds.
Leveraged Buyouts (LBOs)
In a leveraged buyout, a group of investors or a firm usually borrow money from a bank to pay a premium for the existing shares of a company from its shareholders to take it private. The money is initially borrowed from a bank as a source of bridge financing until it can issue junk bonds after taking over the company. The proceeds of the junk issue are used to pay off the bank loans. In most cases, the company's outstanding bonds become fallen angels, because of the debt burden and the resulting lower credit rating. To protect bondholders, many new issues of bonds have change-of-control covenants, which allow the bondholders to sell the bonds back to the company for par value or some other stipulated value if there is a change of control of the company.
Sometimes the junk bond issuer will deem itself to have a better future than would otherwise be indicated by its current low credit rating. In the hopes to prosper in the near future, some issuers add clawback provisions to the bond's indenture that allows the company to buy back the bonds, generally within 3 years of issuance, if the source of the funds is from a primary or secondary stock offering. The percentage of bonds that can be retired using clawback provisions ranges from 20% to 100% with bondholders typically receiving about 110% of par value for the early retirement.
Types of Junk Bonds
Because many issuers of junk bonds are financially distressed and are hoping for a better financial future, the indentures of many of these issues provide an alternative means of paying interest, in most cases, either deferring paying cash interest, paying less initially, or making it optional. Generally, the period of no or low interest payments ranges from 3 to 7 years. Afterwards, the companies hope to have a great enough cash flow to make payments of interest and principal.
Deferred Interest Bonds (DIBs) and Pay-in-Kind Debentures (PIKs)
There are 2 special kinds of zero-coupon bonds that are issued by junk issuers: deferred interest bonds and pay-in-kind debentures. Although these types are often referred to as zeros, because they are sold at a discount, they pay interest that is additional to the principal amount.
Deferred interest bonds (DIBs) pay interest only after a specified date, which is 5 years in most cases. Some DIBs pay interest only at maturity—however, the interest is in addition to the principal payment.
Pay-in-kind debentures (PIKs) gives the issuer the option of either making a cash interest payment or an interest payment of more PIKs for a specified period of time that generally ranges from 5 to 10 years. After this period, if the company is not in default, the coupon payments are in cash.
Both of these bonds have an extremely high credit risk. Although this debt is senior to stocks, it is subordinated to all other loans and bonds that have been previously issued by the company. Because no payment will be received until sometime well into the future, an investor would need to evaluate the company's prospects until that time. Would it be able to generate enough cash to pay off all of its loans and senior bonds with enough left to pay its junk zeros? If not, the investor could well lose her entire investment.
Step-Up Bonds and Extendible Reset Bonds
Step-up bonds pay an initially low coupon rate, but then, after a specified period of time, the coupon rate is stepped up.
The extendible reset bond has its coupon rate reset so that the market price of the bond is equal to its par value or some percentage of it. The coupon rate may be reset periodically, such as annually, or for a specified number of times, which, in many cases, may only be once. The reset interest rate is determined by the opinions of at least 2 investment banks.
The extendible reset bond differs from a floating-rate bond in that the interest rate is not a specified amount in relation to an index or some other fixed-rate security, such as a Treasury, but is the result of the opinions sought from investment banks based on prevailing interest rates or what credit spread the market requires in order to maintain the bond prices in the secondary market at par value.
The issuer of the extendible reset bond hopes to lower the yield that the issuer would otherwise have to pay by accepting some of the interest rate risk and the credit risk of the issue. While the floating-rate bond offers some protection against interest rate risk, the extendible reset bond also offers some protection against credit risk, since, if the issuer's credit rating declines, it would have to pay a higher coupon rate even if prevailing interest rates decline. However, because of the low credit rating of the issuer and its inability to pay high rates for lack of cash flow, the prices of the bonds often cannot be maintained at par level, with the result that the prices decline anyway.
In the News, 10/3/2008 -
Credit Crisis Lowers Price of Junk Bonds
During the credit crisis of 2008, bond yields increased dramatically while the yields of safe Treasuries declined to almost zero—at one point the interest rate on a T-bill was actually negative as a result of the massive flight to quality!
Consequently, junk bonds were selling for prices yielding 12% more than Treasuries with comparable maturities. Junk bonds dropped 23%, paying 74.5 cents to the dollar in the secondary market on average, which some companies, such as Charter Communications, Inc., Freescale Semiconductor, Inc, and Yankee Candle Company, saw as a buying opportunity to buy back their junk bonds to reduce interest costs.