Long-term Corporate Debt: Investment-grade (IG) Vs. High-yield (HY) Bonds

Corporate issuers use long-term debt to secure stable funding for a range of requirements, from short-term operations to long-term capital investments. However, the features and availability of such funding vary based on the credit quality of the issuer. While IG corporate issuers showcase a strong capacity to meet future obligations, HY issuers are vulnerable in meeting debt interest and principal payments.

Similarities between IG & HY Issuance

Both IG and HY issuers are confronted with a series of considerations when issuing long-term debt. They weigh the relative risk against its costs or yield-to-maturity of long-term debt of different maturities. Moreover, both categories of issuers need to address concerns associated with interest rates, credit spreads, and maturity choices. The overarching issues of price risk, reinvestment risk, and rollover risk further bind these issuers in their decision-making process.

Distinguishing Features of IG and HY Bonds

Investment-grade Bonds

• IG bonds often possess a lower proportion of YTM that’s attributed to credit spreads.
• These bonds come with fewer restrictions for issuers, primarily because they’re less likely to default.
• Cash flows from IG bonds are more predictable, aligning more with traditional bond characteristics.

High-yield Bonds

• Their cash flows resemble equity investments, carrying an inherent uncertainty.
• A significant portion of their YTM is credited to issuer-specific spreads over benchmark yields, owing to the increased likelihood of default.
• These bonds often come laden with restrictions, and many are secured by tangible assets to appease wary investors.

Analytical Approach to IG and HY Bonds

For IG Bonds, analysts typically lean on financial ratios and credit ratings to gauge the potential shift in an IG issuer’s likelihood of default. On the other hand, given their high-risk profile, HY bonds demand a more intricate analysis. Emphasis is placed on evaluating potential losses in the event of default. Moreover, analysts closely examine covenants, restrictions, and security pledges tied to HY bonds.

Bond Maturities and Restrictions

Investment-grade Bonds:

• IG issuers have a high flexibility in choosing maturities (up to 30 years).
• Their bonds typically carry few, if any, restrictive covenants.

High-yield Bonds:

• Their landscape is more restrictive, marked by shorter maturity horizons, usually capped at 10 years.
• Given their risk profile, these issuers often find themselves renegotiating covenants or restructuring their debt to capitalize on favorable borrowing rates.

Investor and Issuer Implications

Investment-grade Bonds:

• There is a high investor confidence in the IG issuer’s ability to meet obligations.
• Typically, IG issuers circulate multiple general obligation unsecured bonds. These bonds lack specific assets as collateral.
• IG Issuers stagger bond maturities across different periods. This strategy aids in risk minimization and ensures consistent capital availability.

High-yield Bonds:

• HY bonds display unpredictable cash flows, similar to equity investments. This volatility stems from the issuer’s comparatively weaker financial standing.
• To mitigate default risks, HY bonds incorporate restrictive covenants. These covenants impose guidelines to safeguard investors.
• HY issuers operate within stringent frameworks. They confront challenges in issuing additional debt and experience marked fluctuations in credit spreads.
• HY issuers, aiming for financial adaptability, explore diverse borrowing options. They often resort to leveraged loans with prepayment features or bonds with contingency provisions.

Fallen Angels

A unique subset within the high-yield universe is the “fallen angels” issuers. These are formerly investment-grade issuers who experienced a decline in their credit rating. However, their bonds still retain features characteristic of investment-grade instruments. These features include being non-callable, having minimal restrictions, and possessing longer maturities. However, any subsequent deterioration in the issuer’s credit quality can precipitate losses for the original investors. This decline is further exacerbated by the fact that the market for high-yield bonds is significantly smaller compared to the market for investment-grade bonds, which can have a pronounced effect on bond prices.

Question #1

In terms of maturities, which bond issuer typically has the flexibility to choose maturities that can extend up to 30 years?

1. High-yield bonds.
2. Fallen Angels.
3. Investment-grade bonds.

Solution

The correct answer is C.

Investment-grade bond issuers have the flexibility in choosing maturities, and these can extend up to 30 years.

A is incorrect: High-yield bonds often have a more restrictive landscape, usually limited to maturities of 10 years.

B is incorrect: While Fallen Angels might retain some features of investment-grade instruments after a credit rating downgrade, the question specifically refers to the typical maturity of a particular type of bond, not a subset of issuers.

Question #2

In the context of credit quality, which of the following bonds typically carries a significant portion of its yield-to-maturity (YTM) attributed to issuer-specific spreads over benchmark yields?

1. Bonds with predictable cash flows.
2. Investment-grade bonds.
3. High-yield bonds.

Solution

The correct answer is C.

High-yield Bonds typically have a significant portion of their YTM credited to issuer-specific spreads over benchmark yields due to the increased likelihood of default.

A is incorrect: The predictability of cash flows does not directly determine the portion of YTM associated with issuer-specific spreads.

B is incorrect: Investment-grade bonds generally have a lower proportion of their YTM attributed to credit spreads, reflecting their lower default risk.