High-yield bonds are issued by organizations that do not qualify for "investment-grade" ratings by any 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 compensate them for the risks associated with investing in organizations of lower credit quality.
While analyzing a high-yield bond, analysts should study about the debt structure, corporate structure and covenant.
1. Analysis of Debt Structure: Debt structure of a high-yield issuer mainly includes bank debt, brokers loans or bridge loans, reset loans, senior debt, senior subordinate debt and subordinate debt.
First, let us look into bank loan. High-yield issuer would rely more on bank loans because its low credit rating would make it a less attractive investment for creditors. Therefore, bank loan constitutes a major part of a firm's debt. The bank debt, which is short-term and secured debts, would give the holders priority over other debt holders on the assets of the firm. When a firm is heavily financed by bank debt, floating interest rates may pose severe cash flow problems to the issuer. One more issue to be considered is how the issuer would pay back the bank loan. There are usually three options available for the issuer, (i). Repayment from operating cash flow (ii). Refinancing and (iii) Sale of assets. Analysts must be careful in examining the source of payment as any discrepancies would affect the ability of the issuer to repay the debt.
When a high-yield issuer turns to broker loans or reset loan for financing, it is of concern to the bond holders. As the coupon rate of the reset note would be changed periodically (so that the security would trade at a price premium above the par value), an analyst should carefully examine the impact of rising interest rates as it could lead to higher borrowing cost.
While analyzing debt structure of a high-yield issuer, the analyst should also look into the fact, whether the issuer has any deferred coupon bonds. A deferred coupon bond, such as a zero coupon bond, is a debt instrument that pays no interest until a date specified in the future. A deferred interest payment implies that the future cash flows would be affected by this obligation. Analysts should carefully examine the effect of this obligation while analyzing a high yield corporate bond.
2. Analysis of Corporate Structure: When high-yield issuers have a holding company structure, an analyst should also look into the operation of the subsidiaries. The analyst should understand the corporate structure of the firm so as to understand the effect of cash flow between the subsidiaries and the parent company. Understanding this is important to analyze the sources of finance for the parent company to pay its creditors. Examining the debt structure of the subsidiary helps the analyst in finding out how much the subsidiaries would be able to contribute to the parent company in paying off its creditors.
3. Analysis of Covenants: An analyst should go for a detailed analysis of the covenants in the bond indenture as it provides insight into the company's strategy. Any loopholes in covenants provide clues about the intentions of the management.
4. Equity Analysis Approach: Analysis of a high-yield bond from an equity analyst's perspective is strongly recommended by some portfolio managers. As per Stephen Esser -
Using an equity approach, or at least considering the hybrid nature of
high-yield debt, can either validate or contradict the results of traditional credit analysis, causing the analyst to dig further.
He further states that for those who work with investing in high-yield bonds, whether issued by public or private companies, dynamic, equity-oriented analysis is invaluable. If analysts think about whether they would want to buy a particular high-yield company's stock and what will happen to the future equity value of that company, they have a useful approach because, as equity values go up, so does the equity cushion beneath the company's debt. All else being equal, the bonds then become better credits and should go up in value relative to competing bond investments.
5. Default Rates on High Yield Securities: There is a difference between default rate and loss rate. Default rate is the proportion of companies defaulting per year. But not all companies that default go bankrupt. The recovery rate is the proportion of defaulting companies that do not eventually go bankrupt. High yield securities are considered to have speculative characteristics. They may have a greater risk of default or may already be in default because of the issuer's low creditworthiness. The default rate on high yield securities is likely to be higher during economic recessions or periods of high interest rates. During the recession of 1990, the default rate was 10 percent, but with growing economy, the default rates have come down. According Moody's FMR Co ( MARE) report, the average historical default rate for September 30, 1986 to February 28, 2007 is 5%.