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High Yield Bonds/Commercial Paper

(Source: Various Sources)


For many companies facing major structural economic changes: foreign competition, technological shifts, deregulation, a missing element for economic adjustment was capital. Bank loans, restrictive private placements, or dilutive stock offerings were the only source of capital prior to the rise of the high-yield market in the United States.

A high yield, or "junk", bond is a bond issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered "speculative" grade or below "investment grade". This means that the chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that "junk" bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk.

High yield or "junk" bonds get their name from their characteristics. As credit ratings were developed for bonds, the credit rating agencies created a grading system to reflect the relative credit quality of bond issuers.

The highest quality bonds are "AAA" and the credit scale descends to "C", and finally to the "D" or default category. Bonds considered to have an acceptable risk of default are "investment grade" and encompass "BBB" bonds and higher. Bonds "BB" and lower are called "speculative grade" and have a higher risk of default.

Rule makers soon began to use this demarcation to establish investment policies for financial institutions, and government regulation has adopted these standards. Since most investors were restricted to investment grade bonds, speculative grade bonds soon developed negative connotations and were not widely held in investment portfolios. Mainstream investors and investment dealers did not deal in these bonds. They soon became known as "junk" since few people would accept the risk of owning them.

Before the 1980s, most junk bonds resulted from a decline in credit quality of former investment grade issuers. This was a result of a major change in business conditions, or the assumption of too much financial risk by the issuer. These issues were known as "fallen angels".

The advent of modern portfolio theory meant that financial researchers soon began to observe that the "risk-adjusted" returns for portfolios of junk bonds were quite high. This meant that the credit risk of these bonds was more than compensated for by their higher yields, suggesting that the actual credit losses were exceeded by the higher interest payments.

Securities rated BBB and above are called/rated investment grade. Securities rated below investment grade are euphemistically called "junk bonds". These securities carry a high degree of risk- primarily those at the lower end of their individual rating scale (CCC)- are considered speculative investments by the major credit rating agencies. The following are excerpts from Moody's and S&P's definitions for speculative grade debt obligations.

Moody's- Ba rated bonds have "speculative elements", their future "cannot be considered assured", and protection of principal and interest is "moderate" and "not well safe guarded". B rated bonds "lack characteristics of a desirable investment" and the assurance of interest or principal payments "may be small". Caa rated bonds are "of poor standing" and "may be in default" or may have "elements of danger with respect to principal or interest".

Standard and Poor's- BB rated bonds have "less near term vulnerability to default" than B or CCC rated securities but face "major ongoing uncertainties.... which may lead to inadequate capacity" to pay interest or principal. B rated bonds have a "greater vulnerability to default" than BB rated bonds and the ability to pa interest or principal will likely be impaired by adverse business conditions. CCC rated bonds have a "currently identifiable vulnerability to default" and, without favorable business conditions, will be unable to repay interest and principal.

High yield bonds may be issued as a result of corporate restructuring, such as leveraged buyouts, mergers, acquisitions and debt recapitalization. These bonds are also issued by smaller, less credit worthy companies or by highly leveraged firms. They are generally less able than more mature larger firms to make scheduled payments or interest and principal.

Vanguard's High Yield Fund prospectus literature also notes that "credit quality in the high yield market can change suddenly and unexpectedly, and even recently issued credit ratings may not fully reflect the actual risks imposed by a particular high yield security."

Note: All commentary refers to high yield funds of acceptable diversification and monitored by a competent manager. Individuals of limited means (most middle income wage earners) should not buy individual issues under almost all circumstances. Non-diversified portfolios contain risk in themselves- and the use of higher risk investments invariably pushes the risk limit too high and makes them unsuitable. Further, the term diversification takes on added dimension when used with lower grade corporates. Due to their thin markets (described below) and the grading of the bonds, some pundits suggest that the portfolio contain at least 75 to 100 issues. They also suggest that the portfolio be reviewed to determine if the bonds are the more actively traded.

Larger, more active issues do not fluctuate as greatly in value and are more liquid for redemptions.

Underwriters being creative and profit-oriented soon began to issue new bonds for issuers that were less than investment grade. This led to the Drexel-Burnham saga, where Michael Milken led a major investment charge into junk bonds in the late 1980s, which ended with a scandal and the collapse of many lower rated issuers. Despite this, the variety and number of high yield issues recovered in the 1990s and is currently thriving. Many mutual funds have been established that invest exclusively in high yield bonds, which have continued to have high risk-adjusted returns.

High yield bond investment relies on credit analysis. Credit analysis is very similar to equity analysis in that it concentrates on issuer fundamentals, and a "bottom-up" process. It is concentrated on the "downside" risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group, and issue type. Due to the high minimum size of bond trades and the specialist credit knowledge required, it is not an appropriate investment option for retail investors.

High yield bond investment relies on credit analysis. Credit analysis is very similar to equity analysis in that it concentrates on issuer fundamentals, and a "bottom-up" process. It is concentrated on the "downside" risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group, and issue type. Due to the high minimum size of bond trades and the specialist credit knowledge required, retail investors will not have the required knowledge to invest.

Thorough credit research is key for knowledge to invest. Experience in equity analysis and corporate credit analysis is required for analysis of un-rated companies. High-yield bonds are more vulnerable to default than investment-grade bonds. Taking the time to research companies can reveal hidden gems and expose concealed weaknesses. A competitive company with solid management and a sound business and financial strategy will likely prosper, even though its credit rating may not be high. A struggling company with weak management and reluctance to adapt to changing business situations is obviously a much higher risk.

In conclusion, when compared to traditional government bond funds, a well-researched high-yield bond portfolio gives the institutional investor some important advantages:

Higher potential returns:

In the United States, high-yield bonds have outperformed government bonds by an average annual rate of 2.5 per cent.* That return advantage can make a big difference over the long term.

Less sensitivity to interest rate changes:

In the US, between 1985 and 1996, almost 94 per cent of the total average annual return for high-yield bonds was income return.* Achieving such a high percentage of their return through income means high-yield bonds will be affected less by changes in interest rates.

Quality research and a patient investment approach are key to the potential benefits high-yield bonds offer to potential investors.

Junk bonds, also known more respectfully as high-yield securities, are debt instruments corporate borrowers issue that and which the major bond-rating agencies say are less than "investment grade." A corporate bond is considered "junk" if it is rated as BaA or lowers by Moody's or Ba3 or lower by Standard and Poor's bond-rating services. Bond ratings measure the riskiness of bonds (that is, the chance that the issuer will be unable to make interest payments or repay the principal). The riskier a bond, the lower its rating. Bonds with more A's are less risky than bonds with fewer A's, and the highest rating (for Standard and Poor's) is AAA, or triple-A.

Credit risk is based on a multitude of factors, many of which are linked to performance in the past. Some of the largest corporations, such as IBM and General Motors, and even the U.S. government were at times below investment-grade rating. Today many companies that are household names, including Time Warner and Duracell, fall into this category.

This means that the companies must pay higher rates of interest on their bond issues than other corporations pay on investment-grade bonds. That is why non-investment-grade bonds also go by the name of high-yield bonds.

Until the late seventies all new bonds sold publicly to large groups of investors were investment grade. The only publicly traded junk bonds were ones that originally carried investment-grade ratings and had subsequently been "downgraded" because the financial strength of the issuing companies had deteriorated. Up until then, companies with ratings below investment grade raised new money by borrowing from banks or through what are called private placements. A private placement is the sale of bonds directly to an investor such as an insurance company. Because private placements are not registered with the Securities and Exchange Commission, the original purchasers cannot easily resell them to other investors. Interestingly, though, no one labeled such bonds as junk. Publicly issued bonds, on the other hand, can be traded freely.

The debt market in the United States changed dramatically after 1977, when Bear Stearns and Company, a New York investment house, underwrote the first original-issue junk bond (that is, the first public sale of new bonds with a junk rating). Soon thereafter, Drexel Burnham Lambert financed seven companies that had previously been shut out of the corporate bond market. By 1983 over a third of all corporate bond issues were non-investment grade, two-thirds of which were new issues.

What explains this explosion in the issue of junk bonds? For one thing, they held enormous appeal for borrowing companies because publicly issued bonds typically carry lower interest rates (because they are more easily resold) than private placements, and they also tend to impose fewer restrictions on the actions of the borrowers (known in the argot of finance as restrictive covenants). For another, research by economists showed that junk bonds ought to have great appeal to investors. W. Braddock Hickman, T. R. Atkinson, O. K. Burrell, and others examined the bond-rating systems and their impact on bond pricing. These academics were the first to quantify the actual risk premiums (the higher interest rates) paid to various bond investors. They were particularly struck by the fact that low-rated debt earned a high risk-adjusted rate of return. In other words, the interest-rate premium on low-rated debt was higher than was justified by the added risk of default. Therefore, someone who bought a diversified portfolio of these risky bonds would do better than someone who bought investment-grade bonds, even after deducting losses on the bonds that defaulted. Michael Milken of Drexel Burnham trumpeted these insights to his firm and his customers, with stunning success.

For many companies facing major structural economic changes - foreign competition, technological shifts, deregulation - a missing element for economic adjustment was capital. Bank loans, restrictive private placements, or dilutive stock offerings were the only source of capital prior to the rise of the high-yield market. But suddenly the high-yield market was liquid enough to provide cost-effective funding alternatives.

That golden age of junk financing lasted roughly a decade and built to a virtual frenzy of new bond issues in 1988 and 1989. That resulted, in 1989 and 1990, in an unprecedented number of defaults by junk bond issuers and the bankruptcy of Drexel Burnham. Almost overnight the market for newly issued junk bonds disappeared, and no significant new junk issues came to market for more than a year.

In the wake of that shakeout and the scandals involving Drexel Burnham, junk bonds have been blamed for a broad range of troubles in the economy, including huge losses by commercial banks, the savings and loan crisis, high unemployment, low productivity growth, and almost everything else that seems amiss in the U.S. financial world. The facts do not support such assertions, but a handful of major bankruptcies of companies that went through leveraged buyouts or made acquisitions with junk bonds has fostered the general impression that they are responsible for many economic woes.

In fact, researchers have found that issuers of high-yield debt as a group have outperformed industrial averages in many important measures of industrial performance, including employment growth, productivity, sales, capital investment, and capital spending. Overall, high-yield firms increased employment at an average annual rate of 6.7 percent, compared with 1.4 percent for industry in general, from 1980 to 1987. High-yield firms also outperformed their industrial counterparts in productivity. In output per hour of labor, industries with higher utilization of high-yield securities were more productive. In sales per employee, high-yield firms averaged 3.2 percent growth annually, compared with an industrial average of 2.4 percent. The total invested capital of high-yield firms grew at an average annual rate of 12.4 percent, compared with 9.9 percent for industry in general. New capital expenditures for property and plant and equipment grew more than three times as fast among high-yield firms as they did for industry in general (10.6 percent vs. 3.8 percent).

The rise of high-yield securities accompanied the general growth of so-called debt securitization—the combining of loans into packages and the issuance of securities that represent claims on the interest and repayment of principal on those loans. Debt securitization has made marketable investment instruments out of such everyday borrowings as home mortgages and credit card debt. Studies indicate that throughout the eighties junk bonds were very profitable investments for S&Ls, second only to credit cards.

Why, then, have junk bonds gotten such a bad reputation? For one thing, top managers of investment-grade companies have been arguing for years that they are the embodiment of reckless excess on Wall Street. They may take that position because junk bonds gave corporate raiders access to the public debt market and enabled them to mount assaults on the largest corporations in the United States. Less dramatically but also of importance, junk bonds make it possible for weaker companies to compete more successfully with investment-grade companies for financing. In addition, it is likely that a herd instinct on Wall Street helped make junk bonds anathema, at least for a while. By 1988 and 1989 Wall Street firms were financing deals that many observers said were bound to fail. But investors went on buying even the shakiest junk bonds. When the poorly structured deals did fail, investors shunned even the strongest junk bonds. But by the summer of 1991, it appeared that junk bonds were on their way back to filling a very useful role in financing U.S. business.

This list of concerns is extensive, as well it should be due to the potential volatility of the investment and the fact that significant losses can and have occurred. Further, the reason for the losses are not simply due to the factual issues of defaults, but primarily the esoteric political and emotional issues surrounding junk bonds. They are not well understood. Some of the concerns are discussed below.

Return

High yield instruments have returned about 350 - 450 basis points higher than T-bills from 1982 to 1988. That, factually, is quite a difference and the reason why they are considered by many seeking a higher return. Is the spread sufficient for the real (or perceived) risk? According to The Handbook of Fixed Income Securities, Chapter 45, High Yield Bond Portfolios, page 982, "the promised yield spread on high yield bonds has been far more than enough to compensate for the credit losses that have been experienced to date."

Default

The major controversy regarding junk bonds- but, it is submitted, NOT the real problem in use- is the perceived "high" default rate. But a review of these bonds from 1974 to 1984 shows that the default rate of all low rated debt instruments was only 1.5% per year. To put that number in perspective, the default rate for all debt from 1950 to 1989 was .15% per year. The default rate did escalate in 1986- 1988 and further studies show the default rate to be between 2.1% and 3.5%. Other studies have also shown that defaults and bankruptcies occur infrequently even among issuers of high yielding securities.

Volatility

Again per The Handbook of Fixed Income Securities, the author of the section, Howard Marks, CFA and portfolio manager, who handled millions of dollars of high yield instruments, noted that the standard deviation on his high yield portfolios (7.4%) was actually less than the Shearson Lehman Government bonds (high rated) (8.2%). This means that there was less volatility in final return than what an investor would have experienced on higher rated government bonds.

Liquidity

Based on the above, high yield funds can provide a return acceptable to risk- BUT only when utilized in managed accounts which are not required to sell any of the debt as demanded by investors for liquidity. And that need identifies an area of risk not in the norm of portfolio use. It is the emotional/perceived risk in 1.) not understanding how the debt instruments may be efficiently used in a portfolio and 2.) recognizing that even if structured properly, there are too many esoteric problems that cause volatility of a fund irrespective of the debt itself. And it primarily has to do with the "illiquidity" of a liquid fund.

The real problem with high yield funds is simply that mutual funds guarantee a market for their shares and must pay out on a sale within seven days of the redemption. Unfortunately, and due to the emotional concerns on these bonds, investors are apt- and do- react to any perceived problem and request, I submit, unnecessary and large redemptions.

Market timers are an "excellent" source for these movements and many have caused havoc with a number of the 47 current funds. For example, in October/November, 1992, market timers pulled out more than $2 billion- about 6% of the total invested on September 30th in high yield bond funds. This landslide caused further investor redemptions with the result of a net loss of 1.59% for that month alone. Other concerns include legislative and regulatory changes that can change the tax status of interest or corporate restructuring. Regardless of the cause, excessive redemptions are a major concern. Some fund managers- mostly no load- are therefore considering instituting back end loads for investors who have not held an account for, say, at least 12 months.

It is important to note that most other bond funds- and some small cap stock funds- are in exactly the same position with thin markets, but that market timers are not as great a concern. But high yield funds are not well understood and therefore suffer greater exposure and risk to emotional plays in the market. The point is however, that understood or not understood, the mere fact that outside influences are negatively impacting the funds must be addressed by the investor.