High Yield Debt

Introduction

What is High Yield Debt?

• Commonly referred to as "junk bonds"
• Consists of corporate bonds rated below investment grade (below BBB-/Baa3)
• By major credit rating agencies

Introduction

What is High Yield Debt?

• Offer higher interest rates to compensate investors for elevated credit risk
• Limited liquidity compared to investment grade bonds
• Greater sensitivity to economic cycles
• Emerged as a distinct asset class in the 1980s

Key Characteristics

Below Investment Grade Ratings:

• Bonds rated BB+/Ba1 or lower reflect higher default probability
• Weaker credit metrics, or greater business risk
• Ratings range from BB (higher quality high yield) to CCC and below (distressed territory)

Key Characteristics

Fixed Rate Structure:

• Unlike leveraged loans which feature floating rates
• High yield bonds typically carry fixed interest rates (coupons) paid semi-annually
• Creating interest rate risk but providing payment certainty

Key Characteristics

Unsecured Obligations:

• Most high yield bonds rank as senior unsecured claims
• Without specific asset collateral
• Though secured high yield bonds exist in certain transactions and industries

Key Characteristics

Longer Maturities:

• Tenors typically range from seven to ten years
• Providing extended refinancing runway compared to bank debt
• But creating duration risk for investors

Key Characteristics

Bullet Repayment:

• Bonds generally feature no scheduled amortization
• With entire principal due at maturity
• Preserving cash flow for operations and growth

Key Characteristics

Incurrence Covenants:

• Rather than quarterly maintenance tests
• High yield bonds include restrictive covenants
• Limiting certain actions only when specific conditions aren't met
• Providing operational flexibility while protecting creditor interests

Structure and Components

Issuance Size:

• Offerings typically range from $250 million to over $1 billion
• $300-500 million representing common middle-market transaction sizes
• Smaller issuances face liquidity and distribution challenges

Structure and Components

Coupon Rate:

• Fixed interest rates generally range from 5% to 10%
• Depending on credit quality, prevailing interest rates, maturity, security status
• Distressed issuers may pay double-digit coupons

Structure and Components

Call Protection:

• Non-call periods typically last three to five years
• After which issuers can redeem bonds at specified premiums declining over time
• E.g., 105% in year four, declining to par

Structure and Components

Equity Clawback:

• Many bonds permit partial redemption (typically up to 35-40% of original principal)
• Within the first three years using equity offering proceeds
• At premium prices (often 103-108%)

Structure and Components

Change of Control:

• Provisions requiring prepayment offers at 101% of par upon ownership changes
• Protect bondholders from deteriorating credit quality
• Following acquisitions or sponsor exits

Structure and Components

Guarantees:

• Subsidiary guarantees from material operating entities provide additional credit support
• With guarantees often released when subsidiaries are sold
• Or under specified conditions

Covenant Structure

Incurrence-Based Framework:

• Covenants restrict actions rather than requiring maintenance of financial ratios
• Permitting activities only when borrowers satisfy specified tests
• Or fall within carved-out baskets

Covenant Structure

Debt Incurrence Tests:

• Additional debt permitted only if fixed charge coverage ratios exceed thresholds (typically 2.0x)
• Or through specified baskets for acquisitions, working capital, or other purposes

Covenant Structure

Restricted Payments:

• Dividends, equity repurchases, and distributions limited by:
• Builder baskets (accumulating portions of net income)
• Declining leverage tests, or available amounts based on historical performance

Covenant Structure

Asset Sales:

• Proceeds from asset dispositions must be reinvested
• Used to prepay debt, or applied to permitted investments
• Within specified timeframes (typically 360-450 days)

Covenant Structure

Affiliate Transactions:

• Limitations on transactions with sponsors, management, or related parties
• Unless conducted on arm's length terms
• And meeting specified approval thresholds

Covenant Structure

Liens and Security:

• Restrictions on creating secured debt that would disadvantage unsecured bondholders
• Often with significant carve-outs for working capital facilities
• And other permitted secured obligations

Covenant Structure

Merger and Consolidation:

• Requirements that surviving entities assume bond obligations
• And meet credit metrics or other tests
• Preventing value-destructive combinations

Comparison with Other Debt Instruments

High Yield vs. Investment Grade Bonds:

• High yield carries higher coupons, more restrictive covenants
• Greater default risk, unsecured status (typically)
• Trades with wider spreads and lower liquidity

Comparison with Other Debt Instruments

High Yield vs. Leveraged Loans:

• Bonds feature fixed versus floating rates
• Longer maturities, unsecured versus secured status
• Bullet versus amortizing structures

Comparison with Other Debt Instruments

High Yield vs. Leveraged Loans (continued):

• Incurrence versus maintenance covenants
• Bond versus loan documentation

Comparison with Other Debt Instruments

High Yield vs. Second Lien:

• Second lien offers secured status, floating rates
• And typically shorter maturities compared to unsecured fixed-rate bonds
• Though bonds generally provide greater market depth and lower all-in yields

Comparison with Other Debt Instruments

High Yield vs. Mezzanine Debt:

• Mezzanine typically includes equity participation features
• Higher yields, greater structural subordination, more negotiated terms
• While bonds offer standardized documentation and broader investor distribution

Role in Capital Structure

Leveraged Buyouts:

• High yield bonds provide significant permanent capital in LBO structures
• Often representing 30-50% of total debt
• Alongside bank facilities and potentially subordinated tranches

Role in Capital Structure

Acquisition Financing:

• Companies issue bonds to fund strategic acquisitions
• Particularly when transaction size or credit profile
• Makes bank financing insufficient or unavailable

Role in Capital Structure

Refinancing Transactions:

• Issuers replace maturing debt, extend maturities
• Reduce interest costs
• Or improve covenant flexibility through refinancing bond offerings

Role in Capital Structure

Dividend Recapitalizations:

• Sponsors extract value from portfolio companies
• Through bond-financed dividend payments
• While maintaining operational control and ownership

Role in Capital Structure

Growth Capital:

• High yield provides permanent capital for expansion
• Capital expenditures, or strategic investments
• Without the covenant restrictions or amortization requirements of bank debt

Advantages for Issuers

Fixed Rate Certainty:

• Locked interest rates eliminate exposure to rising benchmark rates
• Providing predictable debt service costs
• And facilitating long-term financial planning

Advantages for Issuers

Extended Maturity:

• Seven to ten-year tenors provide substantial refinancing runway
• Reducing near-term maturity pressure and refinancing risk
• Compared to shorter bank facilities

Advantages for Issuers

Covenant Flexibility:

• Incurrence-based covenants provide operational freedom
• Eliminating quarterly maintenance testing
• Reducing technical default risk during business volatility

Advantages for Issuers

No Amortization:

• Bullet structures preserve cash flow for operations
• Growth investments, and strategic opportunities
• Rather than mandatory debt reduction

Advantages for Issuers

Market Depth:

• Well-developed institutional and retail investor base
• Provides reliable access to substantial capital
• For appropriately priced offerings

Advantages for Issuers

Balance Sheet Flexibility:

• Covenant baskets and exceptions enable acquisitions, investments
• And strategic actions
• Without requiring lender consents that bank facilities might demand

Advantages for Investors

Higher Yields:

• Credit spreads provide attractive returns above investment grade bonds and government securities
• Compensating for elevated default risk

Advantages for Investors

Diversification:

• High yield exhibits different risk-return characteristics
• And economic sensitivities compared to investment grade fixed income and equities
• Enhancing portfolio diversification

Advantages for Investors

Total Return Potential:

• Bonds trading below par offer capital appreciation opportunities
• If credit quality improves or if held to maturity

Advantages for Investors

Covenant Protections:

• Incurrence covenants, change of control provisions
• And asset sale restrictions provide downside protections
• While permitting operational flexibility

Advantages for Investors

Market Liquidity:

• More developed secondary markets compared to private debt
• Enable portfolio rebalancing, tactical trading
• And exit flexibility

Advantages for Investors

Established Infrastructure:

• Standardized documentation, trustee administration
• Rating agency coverage, and market conventions
• Reduce information asymmetry and operational complexity

Pricing Mechanisms

Credit Spreads:

• Yields quoted as spreads over comparable Treasury securities
• Typically ranging from 300 to 800 basis points
• Depending on credit quality, maturity, security, and market conditions

Pricing Mechanisms

Ratings Impact:

• BB-rated bonds (higher quality) trade at tighter spreads than single-B rated (mainstream high yield)
• Which trade tighter than CCC-rated (distressed)
• With typical spread differentials of 200-300 basis points between rating categories

Pricing Mechanisms

New Issue Premiums:

• Primary market offerings typically price 25-50 basis points wider
• Than comparable secondary market bonds
• Compensating investors for commitment and providing distribution incentive

Pricing Mechanisms

Market Conditions:

• Spreads widen during economic uncertainty or market volatility
• And tighten during strong economies or robust risk appetite
• Creating significant pricing variability across cycles

Pricing Mechanisms

Issuer Characteristics:

• Industry sector, leverage levels, sponsor quality
• Business model, competitive position, and management track record
• All influence pricing and investor demand

Call Protection and Redemption

Non-Call Periods:

• Absolute prohibition on redemption during initial years
• Protects investors from refinancing risk
• Non-call periods typically extending three to five years from issuance

Call Protection and Redemption

Make-Whole Provisions:

• Some bonds permit early redemption at make-whole prices
• Calculated to compensate investors for lost interest through maturity
• Using Treasury rates plus specified spreads

Call Protection and Redemption

Optional Redemption:

• After non-call expiration, issuers can redeem at declining premiums
• E.g., 105% declining to 100% over several years
• Balancing issuer flexibility and investor protection

Call Protection and Redemption

Equity Clawback:

• Permits early partial redemption using equity proceeds at premium prices
• Enabling sponsors to reduce debt
• When equity markets provide attractive terms

Call Protection and Redemption

Asset Sale Proceeds:

• Excess proceeds from asset sales may require bond repayment offers at par
• Providing liquidity to investors
• While enabling issuers to reduce leverage

Default and Recovery

Default Rates:

• Historical annual default rates average 3-5% across market cycles
• With significant variation ranging from under 1% in strong economies
• To 10%+ during recessions or crises

Default and Recovery

Recovery Rates:

• Senior unsecured bonds historically recover 30-40% of principal in default
• Compared to 70-80% for senior secured loans
• Reflecting unsecured status and subordination to secured claims

Default and Recovery

Bankruptcy Treatment:

• Bonds rank as general unsecured claims in bankruptcy
• Receiving distributions after administrative expenses, secured claims, and priority obligations
• But before equity

Default and Recovery

Covenant Protection:

• Limited covenant packages in high yield mean fewer technical defaults
• From financial underperformance
• With most defaults arising from payment failures or bankruptcy filings

Default and Recovery

Distressed Trading:

• Bonds trading below 80 cents enter distressed territory
• With different investor bases (distressed debt specialists, hedge funds)
• And pricing dynamics focused on recovery analysis

Risk Considerations

Credit Risk:

• Elevated default probability compared to investment grade securities
• Represents primary risk
• Particularly during economic downturns or industry-specific challenges

Risk Considerations

Interest Rate Risk:

• Fixed coupons create inverse relationship between bond prices and interest rates
• Rising rates cause price declines
• With longer maturities experiencing greater sensitivity

Risk Considerations

Liquidity Risk:

• Secondary market liquidity varies significantly across issuers and market conditions
• Smaller issues or distressed credits experiencing wide bid-ask spreads
• And limited trading

Risk Considerations

Refinancing Risk:

• Issuers must refinance at maturity
• Credit deterioration or adverse market conditions
• Can make refinancing difficult, expensive, or impossible

Risk Considerations

Covenant Risk:

• Light incurrence covenants provide limited protection against value leakage
• Through dividends, asset sales, or debt incurrence
• Compared to bank facility maintenance covenants

Risk Considerations

Call Risk:

• Issuers can refinance when rates decline
• Forcing investors to reinvest at lower yields
• And eliminating expected interest income

Market Infrastructure

Underwriting Process:

• Investment banks underwrite offerings
• Market securities to institutional and retail investors
• Provide pricing guidance, and facilitate distribution

Market Infrastructure

Rating Agency Coverage:

• Moody's, S&P, and Fitch provide credit ratings
• Ongoing surveillance, and rating updates
• That influence pricing, investor eligibility, and market perception

Market Infrastructure

Trustee Administration:

• Bond trustees monitor compliance, distribute payments
• Hold collateral (if applicable)
• And represent bondholder interests in defaults or amendments

Market Infrastructure

Trading Platforms:

• Bonds trade over-the-counter through dealer networks
• With TRACE (Trade Reporting and Compliance Engine)
• Providing post-trade price transparency

Market Infrastructure

Investor Base:

• Mix of institutional investors (insurance companies, pension funds, mutual funds, hedge funds)
• And retail investors
• Accessing through bond funds or direct purchases

Documentation

Indentures:

• Comprehensive legal agreements between issuers and trustees
• Governing bond terms, covenants, events of default
• And bondholder rights

Documentation

Supplemental Indentures:

• Additional documents adding guarantors
• Releasing guarantees
• Or modifying terms subject to specified consent requirements

Documentation

Offering Memoranda:

• Detailed disclosure documents providing financial information
• Business descriptions, risk factors, and use of proceeds
• For Rule 144A/Regulation S offerings

Documentation

Registration Rights:

• Many bonds include rights to exchange into SEC-registered securities
• Or require registration statements
• Within specified periods

Conclusion

• High yield debt represents a critical component of corporate finance
• Providing companies below investment grade with access to capital markets
• For growth, acquisitions, and balance sheet management

Conclusion

• Fixed-rate structures, extended maturities, and incurrence-based covenants
• Offer issuers predictability and flexibility unavailable in bank markets
• While investors receive enhanced yields compensating for elevated credit risk

Conclusion

• The market's evolution has created sophisticated infrastructure
• Supporting reliable execution, transparent pricing, and diverse investor participation

Conclusion

• Understanding high yield bond mechanics—including covenant frameworks, call protection, default dynamics
• And recovery expectations—is essential for both issuers optimizing capital structures
• And investors seeking attractive risk-adjusted returns

Conclusion

• Success in high yield markets requires balancing operational flexibility with prudent leverage
• Maintaining financial discipline despite covenant freedom
• And carefully managing refinancing risk as maturities approach