High Yield Bonds

What are High Yield Bonds?

Once considered a risky proposition, the market for high yield bonds has grown to a large, yet stable market for availing capital to noninvestment-grade companies who do not meet the credit rating guidelines established by S&P, Moody's, and Fitch.

During the LBO explosion in the 1980's, many non-traditional financing vehicles were set in place to handle short-term borrowing needs; however, in recent years, the market has stabilized and gone back to the basic borrowing vehicles. These are plain vanilla cash-pay, fixed rate debt. There are still situations that require more non-traditional lending practices but these are not seen as readily as they were in the past. They are primarily used to finance high growth industries that have high funding needs and longer term revenue generating streams.

Let's cover some of the basic types of debt securities issued in the high yield bond market.

Plain Vanilla Fixed Rate, Cash Pay Securities

Out of all high yield bond securities, plain vanilla securities are the most widely used. They are exactly as they sound; they pay a cash interest payments at a fixed rate. These securities typically have a term to maturity of 7 to 12 years and have a callable option built in within the first 3 to 5 years to allow for a company to pay off expensive debt as their revenues and credit ratings improve. The corporation can then issue more lower yield debt as a substitute due to their improved position.

Rule 144A Securities

Rule 144A securities has become a very desirable technique for companies to quickly access the credit markets. Rule 144A allows companies to bypass the typical four weeks review period required by the SEC before bringing the security to market. This bypass is done through the use of underwriters. Companies will sell the high yield bonds to an underwriter and the underwriters will, in turn, sell these securities in the secondary market under the safe harbor resale provisions provided by Rule 144A. The issuing company will be responsible for registering these securities within a maximum of 90 days.

Payment-in-Kind Securities

Payment-in-Kind securities is exactly as it sounds. Issuers will be allowed to pay the investor by issuing them more debt securities rather than actually paying the cash interest payment. PIK increases the corporations debt and future cash interest obligations. In comparison to other high yield bonds, PIK's trade without accrued interest.

Split-Coupon Securities

Another popular form of high yield bonds is known as split-coupon securities. As with all the other types of high yield bonds we have discussed, split coupons are used by issuers who lack the funding to make large capital expenditures, in the form of interest. Split coupon securities being with the security being a zero coupon bond which does not make coupon payments. To compensate for this, the bonds are issued at a discount to par. This initial period in which no coupon payments are made usually last anywhere between three and seven years long. After that period, the security begins to pay coupon payments.

Some corporations will actually overfund the issuance in order to pay the coupon payments so that they can avoid issuing zeros, which some investors cannot buy into as they need to buy into cash paying securities.

Step-Ups

Very similar to split-coupon securities, step-ups are high yield bonds which pay low coupon payments in the first three to five years and then increase, or step up, the coupon payments in the remaining years until maturity.

Bond/Stock Units

Another creative way of issuing high yield bonds involves packaging the bond securities with actual stock, or equity. Typically, between 10 and 15 percent equity ownership is issued to the bond holders in place of interest payments. The bond holder can either sell the stock immediately or hold it in the prospects of share price increases.

High Yield Bank Loans

The market for high yield banks loans has substantially grown in recent years. With the massive amount of liquidity in the credit markets, banks have been issuing high yield loans at an increasing rate. There is a downside of these bank loans; they carry floating interest rates which can be detrimental to a company. Additionally, they are callable at any time and usually require borrowers to pledge assets to secure the loan. Compared to the high yield bonds market, bank loans also have many other restrictions that make it more difficult for borrowers to abide by the bond covenants.

Tim Ord
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