High Yield bonds are a form of debt issued by companies. Companies issue High Yield bonds to fund an acquisition, refinance existing debt, or for investment in the business. They are also frequently used by private equity groups to raise cash to buy companies. High Yield bonds are commonly referred to as “junk bonds”– this term gives this class of fixed income investment a reputation as being too risky for many investors. The purpose of this article is to demystify High Yield bonds and to explain why calling them “junk” is a misnomer. In DIA’s opinion, High Yield bonds should be a part of an investor’s diversified portfolio.
The history of High Yield is important in understanding the origin of the name “junk bonds.” Prior to the 1980s, nearly all corporate debt was issued by the largest and safest companies. The investment market was not as mature and diverse as it is today, and the market for the debt of lower credit quality companies was minimal. In the 1980s the market began to change and companies with weaker credit profiles began issuing bonds as well, setting the stage for the investment bank Drexel Burnham Lambert and a banker named Michael Milken to transform High Yield bonds into a major market. The development of the High Yield bond market occurred in conjunction with the growth of the private equity industry and leveraged buyouts. Drexel Burnham Lambert established itself as the market leader in the High Yield market, engineering a massive level of bond issuance in the late 1980s. Companies readily issued these bonds and unfortunately in many cases took on far too much debt; it was at this time that the name “junk bonds” came into use. Milken was later convicted of insider trading and in 1990 Drexel Burnham filed for bankruptcy. The association of Milken added further negative connotations to the High Yield market. The use of High Yield debt declined sharply after this, but still remained a staple of corporate debt issuance, and continues to be an important part of the credit and capital markets today. Unfortunately, the name “junk bond” that was perhaps deserved in the 1980s stuck and is still used today.
What exactly makes a bond a High Yield bond and how does it differ from other corporate bonds? We first have to understand the role of the credit rating agencies, led by Standard & Poors (S&P) and Moody’s. These two firms independently rate debt issued by corporations and other entities so that an investor can get a sense of the quality of a bond without doing any further research (not very well according to many observers, especially after they botched the ratings for many mortgage securities pre-2009). S&P and Moody’s each have their own letter grading scoring systems, but they are essentially the same. According to market convention, an “investment grade” rating means a rating of at least BBB- by S&P and Baa3 by Moody’s. Anything below this rating, which means BB+/Ba3 or lower, is called “non-investment grade” or “High Yield.” Does the fact that a company has a “non-investment grade” rating mean that the bond is inherently a bad or “junky” investment? No – and this is why the terms “investment” and “non-investment” grade are misleading. These terms simply mean that one class of bonds, based solely on the ratings of S&P and Moody’s, is relatively riskier than the other class of bonds.
Stepping back further, let’s review some of the basics of a corporate capital structure. When a company issues debt and equity to raise capital each class of investor has certain claims on the value of the company. First in line are the lenders or the investors who purchase the bonds issued by the company. Next in line are the stockholders. So even though “junk bonds” are “non-investment grade,” they still have priority of payment over the stockholders – yet, no one calls an investment in the stock of these same companies “junk stocks.” But in fact, the risk as a stockholder is much greater than that of the bond holder, even the “junk bond” holder. A bond holder is entitled to a contractual right to earn interest and be repaid on the maturity date of the bond; only a bankruptcy would disrupt this contractual obligation. The stockholder does not enjoy these protections.
Many stock investors may not realize that there are numerous High Yield bond issuers that are public, and many are included in the S&P 500 index as the largest public companies in the U.S. Many more High Yield issuers are included in broader stock indexes like the Russell 2000 and in other well invested asset classes like MLPs. Some of these large companies that are “junk bond” issuers include Alcoa, AMC Networks, Cablevision Systems, Chesapeake Energy, Healthsouth Corporation, Iron Mountain, Netflix, Owens-Illinois, Regency Energy, Sprint, Tenet Healthcare, and Tesoro. It is likely that these, and many other “non-investment grade” names are in most stock portfolios.
The key point is that the word “junk” is a vestige of 1980s excesses in corporate debt and not reflective of the broader High Yield market today. Based on long-term return and risk measurement data, and our own experience, High Yield bonds are less volatile than stocks and offer an attractive contractual stream of interest income. DIA typically prefers to purchase a portfolio of individual bonds and hold these bonds to maturity. Through diversification, the risk of a high yield portfolio can be greatly reduced so that a single bond that underperforms will have a minimal impact on long term returns. The data supports the benefits of High Yield bonds. The BofA Merrill Lynch U.S. High Yield Index shows a 10-year annualized return (through 8/31/14) of 8.6% versus 8.3% for an S&P 500 stock portfolio over the same time period – and importantly, the High Yield index exhibited about 1/3 less risk than stocks.
Note that this article was written to provide information and education, and is not intended to be considered investment advice, which can only be provided by DIA following a consultation and execution of an Investment Advisory Contract.