The high yield bond market also known as the cash market is a very vigorous and evolving market that has been growing over the last 20 years.  The market is much bigger than the equity market and has typically offered equity-like returns in the long  term, but with less volatility. Some of the assets that trade in the high yield bond market are high yield bonds, leveraged loans, credit default swaps (CDS) and other synthetic products. 

 

The market is less sensitive to interest rate risk due to the floating nature of interest rates and the low duration of assets that trade in that space, it also has a low correlation to other  sectors of the fixed income market. Bonds and loans that trade in the market offer interest rates that are higher than government and investment grade bonds due to their  higher risk of default on payments. 

 

Size of the Market:

 

The high yield bond market alone in August of 2013 totaled over $2 Trillion in dollar dominated debt, compared to $247B in 1997 according to Bloomberg. The Credit Default Swaps and Leveraged loan markets had outstanding values in excess of  $25.5 Trillion and $625B in the second half of 2012. 

 

The companies that raise debt in the high yield market are classified as high yield issuers and usually have credit ratings of a double –B or below. High yield issuers have low credit ratings that are below investment grade, which implies a  higher risk of default on interest and principal payments due to weak and deteriorating financials.

 

Why Investment graded companies are able to raise money at cheaper rates than high yield rated companies.

 

Investment graded companies are highly rated and are able to raise money at cheaper rates than high yield issuers because of their strong financial profiles and stability, which implies that they are financially sound and thus can issue debt and meet those debt obligations without risk of default.

 

Types of high yield issuers: There are 3 types of high yield issuers.

 

 

• Original issuers: who are new and growing companies with wonderful prospects, but lack stronger financial profiles to enable them raise money cheaply.

 

• Fallen Angels: These are companies that were formally investment rated but now have waning balance sheets and deteriorating coverage metrics due to tough times and thus have a hard time raising debt in the normal credit markets due to credit rating downgrades.

 

• Companies engaged in Shareholder-friendly activities: These are companies that have increased debt burden and leverage due to share-holder friendly activities that results in an increase in the financial risk profile of the company.

 

Some of the common sectors that raise money in the high yield bond market are Cable/Media, Energy, Gaming, Utilities, Healthcare, Telecom/Wireless, Autos, Technology, Home Builders and others. Most of the money that is raised from the high yield market is usually used for Merger and acquisition activities, refinancing of debt, Project finance, Shareholder-friendly activities and working capital needs.

 

Types of bond structures

 

Most of the recent debt issues in the high yield market have bond structures that are different from the conventional structure of bonds that pay a fixed coupon rate and the principal at maturity. Some of the new issues have structures that are deferred interest bonds, payment in kind bonds and step-up bonds. The primary reason why issuers are issuing bonds that have such diverse structures are because of the cash retainment features in these bonds which enable issuers reserve cash by not making near term coupon payments.

 

Step up bonds: do not pay cash coupon interest for a period, the coupon rate is usually low for an early period and then rises to a higher coupon rate. The increase in rate can usually be triggered by a range of factors with an example being a ratings downgrade.

 

Deferred-interest bonds: sell at a steep discount and do not pay interest for an initial timeframe, usually from three to seven years

 

Payment – in kind (PIK) bonds provides the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond for payment.

 

Credit Rating and their influence in the high yield bond market:

 

Credit ratings serve as a way for investors to assess a bonds credit risk, and also influence how much interest an issuer pays on a bond . Ratings determine who invests in the bond because some asset managers have a limit on how much of a certain rating of bonds they can hold in their portfolio. 

 

The high yield bond market plays a vital role in the ever changing investment landscape.  The market can enhance portfolio return comparable to equities in the long term but with less volatility. The average recovery for  high yield bonds are also around 40% compared to equities that have next to nothing in the event of bankruptcy. High yield bonds can also offer higher returns than equities with increased leverage and lower volatility.