junk bond

A corporate bond having a high yield and high risk.

A bond rated 'BB' or lower because of its high default risk.

Also known as a "high-yield bond" or "speculative bond".

Investopedia Says:
These are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues.

Related Links:
Don't be fooled by the name - junk bonds may be for you if you know how to analyze them. Junk Bonds: Everything You Need to Know
Avoid these errors made daily in bond portfolios everywhere. Common Mistakes By Fixed-Income Investors
Despite their reputation, the debt securities known as "junk bonds" may actually reduce risk in your portfolio. High Yield, Or Just High Risk?
Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy. Corporate Bonds: An Introduction To Credit Risk
Investing in bonds - What are they, and do they belong in your portfolio? Bond Basics Tutorial

Bond issued by companies whose credit ratings are below investment grade, and generally given a bond rating of BB or lower by bond rating agencies. Bond ratings higher than BB are possible, though, through overcollateralization. To attract investors, junk bonds pay a higher interest rate than Investment Grade bonds and are regarded as speculative investments, because the bond issuers either are unknown in the market or are well-known companies that are highly leveraged. The bonds pay higher yields because the credit risk is greater than in investment grade issues. Junk bonds are frequently issued by companies to finance a Leveraged Buyout a transaction in which investors acquire a company by issuing new debt, using the company's assets as collateral. The takeover debt is retired by selling assets or is paid off from company cash flow. Also called high-yield bond.

For more information on junk bond, visit Britannica.com.

Michael Milken, the notorious investment banker of the 1980s, allegedly coined the term "junk bonds" to describe the portfolio of low-grade bonds owned by one of his early clients, Meshulam Riklis. Companies issue low-grade, also called "high-yield," bonds at high interest rates because of the associated high risk of nonpayment. Unlike investment-grade bonds, the low-grade variety is not backed by assets or cash-flow statements. Companies frequently issue these bonds as a way of borrowing money. An outside, third-party credit rating agency, such as Moody's Investors Service or Standard and Poor's Corporation, judges the creditworthiness of such companies and then ranks them from least to most likely to default. The more financially secure the company, the less risky the debt, or bond. A bond's rating can be downgraded to "junk" status if the company gets into financial trouble. Historically, the use of junk bonds has been a minor part of Wall Street's activity because of the high risks. In the 1920s, however, high-yield bonds flourished. Tempted by the skyrocketing stock market in the 1920s, companies issued bonds with high interest rates in order to raise money by cashing in on booming stock profits and the robust economy. When the market collapsed in 1929, many companies defaulted on the low-grade bonds, and many investment-grade bonds were downgraded to junk status.

For forty years, Wall Street shunned high-yield bonds. In the late 1970s, Milken, as an investment banker with Drexel Burnham, rediscovered their potential. He encouraged his clients, largely fringe players on Wall Street, to issue junk bonds, and within a few years he, his company, and his clients became very successful. Milken's success bred imitators, and junk bonds became a popular way to raise money. In 1984 companies issued close to $16 billion in high-yield bonds—ten times the amount in 1981. In 1986 more than $33 billion worth of high-yield bonds were issued. Profits from the sale of junk bonds frequently financed mergers and acquisitions through leveraged buyouts and hostile takeovers. The transactions involved high fees, which induced investment bankers to underwrite increasingly risky bonds and to engage in fraud. Companies lured by the successes of earlier junk-bond deals took increasingly greater risks in issuing bonds. Enticed by the high interest rates, buyers continued to purchase the risky bonds.

The frenzy lasted until 1989, when the junk-bond market collapsed as the economy went into a recession and companies could no longer generate profits to pay their debts. In 1990 companies issued a mere $1.4 billion in high-yield bonds. Defaults totaled $20 billion. Milken and his imitators, such as Ivan Boesky, were disgraced, and many went to jail for fraud. Milken himself served time and paid fines for six counts of securities fraud.

Junk bonds left a dual legacy. They provided financing for the cable television and computer industries and encouraged companies to emphasize efficiency to realize profits to pay off the high interest on the bonds. On the flip side, the unchecked and frantic pace of the junk-bond market led to fraud, overspeculation, layoffs, and lost fortunes.

In the 1990s, the junk-bond market partially recovered despite the scandals of the previous decade. The high returns possible on such risky deals continue to make them attractive to daring investors. Some less adventurous investors, however, have attempted to temper the risks of purchasing junk bonds by placing their money in special mutual funds that deal solely in high-yield bonds rather than buying junk bonds directly themselves. This approach allows them to depend on the investment savvy of specialists in the field of low-grade bond trading.

Bibliography

Auerbach, Alan J., ed. Mergers and Acquisitions. Chicago: University of Chicago Press, 1988.

Platt, Harlan D. The First Junk Bond: A Story of Corporate Boom and Bust. Armonk, N.Y.: M.E. Sharpe, 1994.

Stein, Benjamin. A License to Steal: The Untold Story of Michael Milken and the Conspiracy to Bilk the Nation. New York: Simon & Schuster, 1992.

Yago, Glenn. Junk Bonds: How High Yield Securities Restructured Corporate America. New York: Oxford University Press, 1991.

A security issued by a corporation that is considered to offer a high risk to bondholders.

Junk bond is the popular name for high-risk bonds offered by corporations. A bond is a certificate or some other evidence of a debt. In the world of corporate finance, a corporation may sell a bond in exchange for cash. The bond contains a promise to repay its purchaser at a certain rate of return, called a yield. A bond is not an equity investment in the corporation; it is debt of the corporation.

A corporate bond is essentially a loan to a corporation. The loan may be secured by a lien or mortgage on the corporation's property as security for repayment.

To determine the level of the default risk for potential bondholders, financial experts analyze corporations and rate them on a number of factors, including the nature of their business, their financial holdings, their employees, and the length of their existence. The higher the risk for bondholders, the lower the risk rating given the corporation.

Because their ventures are considered risky, low-rated corporations must offer bond yields that are higher than those of high-rated corporations. High-rated corporations have less need for income from bonds, so they do not need to offer high yields. Bonds from these companies are called investment-grade bonds. Low-rated corporations have the need for bond income, so they offer high-yield bonds. These high-yield bonds are junk bonds.

When a corporation fails, bondholders may lose all or part of their investment if the corporation has declared bankruptcy or has no assets. This possibility is more real for junk bonds because they are, by definition, issued by unproven or unhealthy corporations.

For some persons, the high yield of a junk bond can be worth the increased risk of default. Junk bonds can increase in value if the corporation's rating is upgraded by private bond-rating firms. Junk bonds are also favored by some persons precisely because they contribute capital to young or struggling corporations. Whether to buy a junk bond depends on the investor: conservative investors do not favor them, but speculators and others seeking a quick profit find them attractive.

Technically known as bonds of “less than investment grade,” they are short-term, high-yield bonds. They were widely used in the 1980s to finance mergers, especially hostile ones.

Financial markets
Bond market
Fixed income Corporate bond Government bond Municipal bond Bond valuation High-yield debt
Stock market
Stock Preferred stock Common stock Registered share Voting share Stock exchange
Foreign exchange market
Derivatives market
Credit derivative Hybrid security Options Futures Forwards Swaps
Other Markets
Commodity market Money market OTC market Real estate market Spot market
Finance series Financial market Financial market participants Corporate finance Personal finance Public finance Banks and Banking Financial regulation
v • d • e

This article needs additional citations for verification. Please help improve this article by adding reliable references. Unsourced material may be challenged and removed. (February 2009)

In finance, a high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated below investment grade at the time of purchase. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors.

Contents 1 Flows and levels 2 Risk 3 Usage 3.1 Corporate debt 3.2 Debt repackaging and subprime crisis 4 High-yield bond indices 5 See also 6 References 7 External links

Flows and levels

Global issue of high yield bonds more than doubled in 2003 to nearly $146 billion in securities issued from less than $63 billion in 2002, although this is still less than the record of $150 billion in 1998. Issue is disproportionately centered in the U.S.A., although issuers in Europe, Asia and South Africa have recently turned to high yield debt in connection with refinancings and acquisitions. In 2006, European companies issued over €31 billion of high yield bonds.^[1]

Risk

The holder of any debt is subject to interest rate risk and credit risk, inflationary risk, currency risk, duration risk, convexity risk, repayment of principal risk, streaming income risk, liquidity risk, default risk, maturity risk, reinvestment risk, market risk, political risk, and taxation adjustment risk. Interest rate risk refers to the risk of the market value of a bond changing in value due to changes in the structure or level of interest rates or credit spreads or risk premiums. The credit risk of a high yield bond refers to the probability and probable loss upon a credit event (i.e., the obligor defaults on scheduled payments or files for bankruptcy, or the bond is restructured), or a credit quality change is issued by a rating agency including Fitch, Moody's, or Standard & Poors.

A credit rating agency attempts to describe the risk with a credit rating such as AAA. In North America, the five major agencies are Standard and Poor's, Moody's, Fitch Ratings, Dominion Bond Rating Service and A.M. Best. Bonds in other countries may be rated by US rating agencies or by local credit rating agencies. Rating scales vary; the most popular scale uses (in order of increasing risk) ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, with the additional rating D for debt already in arrears. Government bonds and bonds issued by government sponsored enterprises (GSE's) are often considered to be in a zero-risk category above AAA; and categories like AA and A may sometimes be split into finer subdivisions like "AA-" or "AA+".

Bonds rated BBB- and higher are called investment grade bonds. Bonds rated lower than investment grade on their date of issue are called speculative grade bonds, derisively referred to as "junk" bonds.

The lower-rated debt typically offers a higher yield, making speculative bonds attractive investment vehicles for certain types of financial portfolios and strategies. Many pension funds and other investors (banks, insurance companies), however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level. As a result, the lower-rated securities have a different investor base than investment-grade bonds.

The value of speculative bonds is affected to a higher degree than investment grade bonds by the possibility of default. For example, in a recession interest rates may drop, and the drop in interest rates tends to increase the value of investment grade bonds; however, a recession tends to increase the possibility of default in speculative-grade bonds.

Usage

Corporate debt

The original speculative grade bonds were bonds that once had been investment grade at time of issue, but where the credit rating of the issuer had slipped and the possibility of default increased significantly. These bonds are called "Fallen Angels".

The investment banker Michael Milken realized that fallen angels had regularly been valued less than what they were worth. His time with speculative grade bonds started with his investment in these. Only later did he and other investment bankers at Drexel Burnham Lambert, followed by those of competing firms, begin organising the issue of bonds that were speculative grade from the start. Speculative grade bonds thus became ubiquitous in the 1980s as a financing mechanism in mergers and acquisitions. In a leveraged buyout (LBO) an acquirer would issue speculative grade bonds to help pay for an acquisition and then use the target's cash flow to help pay the debt over time.

In 2005, over 80% of the principal amount of high yield debt issued by U.S. companies went toward corporate purposes rather than acquisitions or buyouts.^{[citation needed]}

Debt repackaging and subprime crisis

High-yield bonds can also be repackaged into collateralized debt obligations (CDO), thereby raising the credit rating of the senior tranches above the rating of the original debt. The senior tranches of high-yield CDOs can thus meet the minimum credit rating requirements of pension funds and other institutional investors despite the significant risk in the original high-yield debt.

The New York City headquarters of Lehman Brothers

When such CDOs are backed by assets of dubious value, such as subprime mortgage loans, and lose market liquidity, the bonds and their derivatives are also referred to as toxic debt. Holding such "toxic" assets has led to the demise of several investment banks such as Lehman Brothers and other financial institutions during the subprime mortgage crisis of 2007-09 and led the US Treasury to seek congressional appropriations to buy those assets in September 2008 to prevent a systemic crisis of the banks.

Such assets represent a serious problem for purchasers because of their complexity. Having been repackaged maybe several times, it is difficult and time-consuming for auditors and accountants to determine their true value. As the recession of 2008-9 bites, their value is decreasing further as more debtors default, so they represent a rapidly depreciating asset. Even those assets that might have gone up in value in the long-term are now depreciating rapidly, quickly becoming "toxic" for the banks that hold them.^[2] Toxic assets, by increasing the variance of banks' assets, can turn otherwise healthy institutions into zombies. Potentially insolvent banks have made too few good loans creating a debt overhang problem.^[3] Alternatively, potentially insolvent banks with toxic assets will seek out very risky speculative loans to shift risk onto their depositors and other creditors.^[4]

On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a Public-Private Investment Partnership (PPIP) to buy toxic assets from banks' balance sheets. The major stock market indexes in the United States rallied on the day of the announcement rising by over six percent with the shares of bank stocks leading the way. ^[5] PPIP has two primary programs. The Legacy Loans Program will attempt to buy residential loans from bank's balance sheets. The FDIC will provide non-recourse loan guarantees for up to 85 percent of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provide the remaining assets. The second program is called the legacy securities program which will buy mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds will come in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program monies, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF). The initial size of the Public Private Investment Partnership is projected to be $500 billion.^[6] Economist and Nobel Prize winner Paul Krugman has been very critical of this program arguing the non-recourse loans lead to a hidden subsidy that will be split by asset managers, banks' shareholders and creditors. ^[7] Banking analyst Meredith Whitney argues that banks will not sell bad assets at fair market values because they are reluctant to take asset write downs.^[8] Removing toxic assets would also reduce the volatility of banks' stock prices. Because stock is a call option on a firm's assets, this lost volatility will hurt the stock price of distressed banks. Therefore, such banks will only sell toxic assets at above market prices. ^[9]

High-yield bond indices

See also: Bond market index

High-yield bond indices exist for dedicated investors in the market. Indices for the broad high yield market include the CSFB High Yield II Index (CSHY), the Merrill Lynch High Yield Master II (H0A0), the Barclays High Yield Index, and the Bear Stearns High Yield Index (BSIX). Some investors, preferring to dedicate themselves to higher-rated and less-risky investments, use an index that only includes BB-rated and B-rated securities, such at the Merrill Lynch BB/B Index. Other investors focus on the lowest quality debt rated CCC or Distressed securities, commonly defined as those yielding 1000 basis points over equivalent government bonds.

See also

• Bond market index
• Thomson Financial League Tables
• Distressed securities
• Martin S. Fridson
• Mezzanine capital

References

1. ^ Edwards, Bryant; et al. (2006). High Yield In France. Latham & Watkins. http://www.lw.com/upload/pubContent/_pdf/pub1715_1.pdf. 
2. ^ "Marketplace Whiteboard: Toxic assets". Marketplace. http://marketplace.publicradio.org/videos/whiteboard/toxic_assets.shtml. Retrieved 2009-03-20. 
3. ^ "Debt Overhang and Bank Bailouts". SSRN.com. February 2, 2009. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1336288. Retrieved February 2, 2009. 
4. ^ "Common (Stock) Sense about Risk-Shifting and Bank Bailouts". SSRN.com. December 29, 2009. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1321666. Retrieved January 21, 2009. 
5. ^ "U.S. Expands Plan to Buy Banks’ Troubled Assets". New York Times. March 24, 2009. http://www.nytimes.com/2009/03/24/business/economy/24bailout.html. Retrieved February 12, 2009. 
6. ^ "FACT SHEET PUBLIC-PRIVATE INVESTMENT PROGRAM". U.S. Treasury. March 23, 2009. http://www.treas.gov/press/releases/reports/ppip_fact_sheet.pdf. Retrieved March 26, 2009. 
7. ^ Paul Krugman (March 23, 2009). "Geithner plan arithmetic". New York Times. http://krugman.blogs.nytimes.com/2009/03/23/geithner-plan-arithmetic/. Retrieved March 27, 2009. 
8. ^ "Meredith Whitney: A Bad Bank Won't Save Banks". businessinsider.com. January 29, 2009. http://www.businessinsider.com/2009/1/meredith-whitney-a-bad-bank-wont-save-us. Retrieved March 27, 2009. 
9. ^ "The Put Problem with Buying Toxic Assets". SSRN.com. February 14, 2009. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1343625. Retrieved February 15, 2009. 

External links

• Junk Bonds: Everything You Need to Know
• High Yield Blog: includes more than 700 credit snapshot reports for free download

v • d • e Bond market Bond · Debenture · Fixed income Types of bonds by issuer Agency bond · Corporate bond (Senior debt, Subordinated debt) · Distressed debt · Emerging market debt · Government bond · Municipal bond · Sovereign bond Types of bonds by payout Accrual bond · Auction rate security · Callable bond · Commercial paper · Convertible bond · Exchangeable bond · Fixed rate bond · Floating rate note · High-yield debt · Inflation-indexed bond · Inverse floating rate note · Perpetual bond · Puttable bond · Reverse convertible · Zero-coupon bond Bond valuation Clean price  · Convexity  · Coupon yield  · Credit spread  · Current yield  · Dirty price  · Duration  · Nominal yield  · Yield to maturity Securitized products Asset-backed security · Collateralized debt obligation · Collateralized mortgage obligation · Commercial mortgage-backed security · Mortgage-backed security  · Yield-curve spread Bond options Callable bond  · Convertible bond  · Embedded option  · Exchangeable bond  · Option-adjusted spread  · Puttable bond  · Z-spread Institutions Commercial Mortgage Securities Association (CMSA) · International Capital Market Association (ICMA) · Securities Industry and Financial Markets Association (SIFMA)

v • d • e Topics on private equity and venture capital Basic investment types Buyout • Venture • Mezzanine • Growth • Secondaries • Equity co-investment History History of private equity and venture capital • Early history of private equity • Private equity in the 1980s • Private equity in the 1990s • Private equity in the 2000s Terms and concepts Buyout Financial sponsor • Management buyout • Divisional buyout Venture Seed money • Startup company • Angel investor • Venture capital financing • Pre-money valuation • Post-money valuation • Venture round • Venture debt • Bootstrap funding Structure Private equity firms and funds • Limited partnership • Limited liability company • Carried interest  • Management fee • Publicly traded private equity ( Business Development Company, Venture Capital Trust) • Private Investment in Public Equity (PIPE) • Pledge fund Investors Institutional Investors • Pension funds • Insurance companies • Fund of funds • Endowments • Foundations Investment Banks • Commercial Banks • High net worth individuals • Family offices • Sovereign wealth funds Related financial terms Undercapitalization • Initial Public Offering (IPO) • Mergers and acquisitions • Leverage • High-yield debt • Capital structure • EBITDA Private equity and venture capital investors • Private equity firms • Venture capital firms • Portfolio companies

This entry is from Wikipedia, the leading user-contributed encyclopedia. It may not have been reviewed by professional editors (see full disclaimer)