Thursday, April 5, 2007


What Are High-Yield Bonds?

All bonds are debt securities issued by organizations to raise capital for various purposes. When you buy a bond, you lend your money to the entity that issues it. In return for the loan of your funds, the issuer agrees to pay you interest and ultimately to return the face value (principal) when the bond matures or is called, at a specified date in the future known as the “maturity date” or “call date.”

High-yield bonds are issued by organizations that do not qualify for “investment-grade” ratings by one of the leading credit rating agencies—Moody’s Investors Service, Standard & Poor’s Ratings Services and Fitch Ratings. Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuer’s ability to pay interest and principal as scheduled.

Those issuers with a greater risk of default—not paying interest or principal in a timely manner—are rated below investment grade. These issuers must pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks associated with investing in organizations of lower credit quality. Organizations that issue high-yield debt include many different types of U.S. corporations, certain U.S. banks, various foreign governments and a few foreign corporations.1

Who Invests in High-Yield Bonds?

A variety of investors participate in the high-yield bond market. They include individuals who invest in high-yield bonds through direct ownership and/or through mutual funds; insurance companies; pension funds and other institutions.

Individual investors purchase individual high-yield bonds, often as part of a well-diversified investment portfolio. They also participate in this market through high-yield bond mutual funds. Mutual funds pool the assets of investors to create portfolios of high-yield bonds. Three separate categories of mutual funds invest in high-yield bonds:

High-yield funds invest primarily in lower-rated bonds.

Income mutual funds invest in a broad mix of income-producing securities, including high-yield bonds, investment-grade bonds, preferred stocks and high-dividend stocks. High-yield bonds usually represent a small portion of their holdings.

Corporate bond funds invest mainly in investment-grade corporate issues, with a smaller allocation to high-yield bonds.

Insurance companies invest their own capital in high-yield bonds. They also participate in the market through “separate accounts” offered in variable insurance and annuity products.

Pension funds invest in high-yield bonds to earn higher rates of return than those available from investment-grade bonds, or as an alternative to investing in an issuer’s stock. Pension fund trustees are fiduciaries that must invest within “prudent man” guidelines and other considerations, which vary from state to state. Recently, in some cases, these guidelines have allowed increased pension fund participation in high-yield bonds.

Collateralized bond obligations (CBOs) are debt instruments that offer many benefits of investment-grade bonds, including current income and a high quality rating. The collateral behind these bonds often consists of a pool of high-yield bonds diversified by issuers and industries, which enables the pool to obtain a higher rating than any individual bond in the pool. CBOs may include several “tiers,” which offer different maturities, or levels of risk.

All information and opinions contained in this publication were produced by The Bond Market Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, The Bond Market Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.

Who Issues High-Yield Bonds?

Over the last decade, diversity has grown among issuers that tap the high-yield market. In the late 1980s, high-yield bonds were generated by a few participants and heavily used to finance merger and takeover activities. Today, the market has broadened to include many dealers and issuers with diverse needs. Issuers of high-yield bonds can be grouped into the following categories:

“Rising stars” are emerging or start-up companies that have not yet achieved the operational history, the size or the capital strength required to receive an investment-grade rating. These companies may turn to the bond market to obtain seed capital. Although start-ups can be risky, credit rating agencies consider their lack of a track record when issuing ratings. So a start-up company that qualifies for a single-B rating should have about the same risk level as a going concern with the same rating. In some cases, bonds may offer the first chance to participate in start-ups, before these companies offer their initial public offerings (IPOs) of stock to the public. Eventually, many rising stars grow to become larger companies with top credit ratings.

“Fallen angels” are former investment-grade companies that are experiencing hard times, which cause their credit to drop from investment-grade to lower ratings. If their prospects improve, some fallen angels can regain their investment-grade status.

High-debt companies (which may be blue chip in size and revenues) leveraged with above-average debt loads that may cause concern among rating agencies. Companies refinancing debt sometimes turn to high-yield bonds to pay down bank lines of credit, retire older bonds or consolidate credit at attractive rates of interest. Companies also turn to the high-yield bond market for capital to fund acquisitions or buyouts, or to fend off hostile takeovers.

Leveraged buyouts (LBOs) create a special type of company that typically uses high-yield bonds to buy a public corporation from its shareholders, often for the benefit of a private investment group that may include senior managers. Some corporate assets or divisions may then be sold to pay down the debt.

Capital-intensive companies turn to the high-yield market when they are not able to finance all their capital needs through earnings or bank borrowings. For example, cable TV companies require large amounts of capital to acquire, expand or upgrade their systems.

Foreign governments and foreign corporations, often less familiar to domestic investors, may rely on high-yield bonds to attract capital. Bonds issued by foreign entities have not been addressed in this booklet in any detail and are not included in the statistical tables throughout. Also, it should be noted that there are other risks—currency risk and political risk—that are unique to bonds issued by a foreign government/corporation and have not been covered in this booklet.

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