HIGH YIELD BONDS
The definition of High Networth Individuals is based on the total net worth of the individuals. The net worth is dependent on the assets and liabilities, or in simpler terms the invested or investible surplus available with the individual. The figure is different from country to country, however, in India, Investors which have more than Rs. 2 crores in investable capital are said to be High Net Worth Individuals (HNWIs or HNIs). Investors that have an investible surplus of between Rs. 25 lakhs and Rs. 2 crores are considered emerging HNIs.
As per definition, Net worth is the amount by which assets exceed liabilities. Hence, one can understand HNIs are those individuals whose assets exceed liabilities by a massive margin. In the same line, individuals who have extraordinarily high asset margins (assets minus liabilities) are considered to be Ultra HNIs or HNWIs. This category is significant because they have separately managed investment accounts and generally require extremely personalized services for investments and banking. Also, HNIs are required to apply separately in a dedicated category in various financial avenues, such as IPO applications.
In this article, we will talk about High Yield Bonds as an investment option for HNIs and understand their features, risks, benefits with context to HNIs. Let’s discuss the details.
WHAT ARE HIGH YIELD BONDS?
High yield bonds are a much talked about source of diversification for investors having long-term time horizons and seeking to maximize yield and total return potential outside of equities. These often move independently from the stock market and are relatively less conservative bonds. These are also called ‘Junk Bonds’ and are a class of corporate debt instruments with a questionable financial credibility of the issuer, which categorizes them as below investment grade.
As the name suggests, the competitive yields of these issues have helped in attracting assets. Many investors have opted for High Yield Bonds for both diversification and to generate additional alpha in their debt portfolio.
- Cash Flow Improvement:
These bonds vary with regard to their maturity and coupon types. The most common structures are designed to allow issuer entities to improve their cash flows by deferring interest payments to the bondholder. This way the risk for the bondholder increases and therefore the issuer is willing to pay a higher interest rate.
In contrast to leveraged loans, which are usually secured on particular assets, high-yield bonds are unsecured. These loans could be either a senior debt obligation or a subordinate obligation..
Covenants on these bonds may restrict payments by the issuer or certain activities that might be detrimental to the interest of the creditor. A put option on such bonds in case of a ‘change in control’ is incorporated by most high yield loans.
Secondary markets of these bonds are an OTC or over-the-counter market where transactions are negotiated between investors and dealers in bulk whereas the primary market for it is dominated by the few major investment banks.
These bonds are taken as a separate asset class since it has a low correlation with other fixed-income securities. This provides an investor with diversification benefits, i.e. higher return potential and an optimum portfolio risk level.
2. Long maturities:
High yield bonds are often issued with 7 to 10 yrs maturity. However, these are typically callable within 3 to 5 yrs.
These bonds are given priority on repayment of capital over common and preferred shareholders in the case of liquidation. Many investors have a question about the safety of these bonds as the entire amount is lost during default. This may be true in certain circumstances. However, in most instances investors do recover some portion of their investment in case of bankruptcies. High yield bondholders get paid before shareholders in case of defaults
4. Enhance Spread:
These bonds offer a significant spread over government securities. Hence, one can gain significantly higher returns in a small period of time in case, especially in times of falling interest rates.
TYPES OF HIGH YIELD BONDS
- Multi-tranche bonds:
These offer the holders several tiers of investment within a single issue. These tires may vary in their credit quality and targeted maturities.
- Extendable Reset Notes:
The right to extend the maturity of outstanding debt exists in these bonds with the new coupon at periodic intervals. An additional perk of put options where the investor can sell back the bond to the issuer entity on a pre-decided date is also offered.
- Convertible Bonds:
These are bonds that can be converted into shares of another security under given terms and conditions. Most often, converted security is the common stock of the issuing company.
- Pay in kind bonds:
It replaces coupons with additional debts which will carry a higher rate than the original debt, but are highly risky in nature.
- Deferred-interest bonds:
These pay no interest to the holder until a deferred future date. Hence higher coupons are paid to make up the delay in cash flows from interest payment.
- Zero-Coupon Bonds:
These bonds are issued at deep discounts and redeemable at par. No interest is earned and given to the holder.
- Split Coupon Bonds:
These bonds offer a certain interest rate on coupons in the early phase of the bond’s life, followed by a second coupon rate in the later phase. Bonds in which the coupon rate increases in the later phase are also referred to as step-up notes.
- Floating Rate and Increasing Rate notes (IRNs)
These bonds pay adjusted or fluctuating coupon rates based on an interest rate benchmark or schedule of payments.
RISKS WITH HIGH YIELD BONDS
1. Credit Risk:
Above-average credit risk is indicated in the low credit ratings of these bonds. The risk of an issuing entity defaulting in the repayment means an investor may lose some or all of the principal amount invested along with any outstanding interest income due.
2. Economic Risk:
These bonds often tend to react strongly to the changes in economic situations. In a period of recession, bond credit quality drops as default often rises, pushing down overall returns.
3. Liquidity Risk:
If a bond is to be sold, the buyers will be few, this is called liquidity risk. This issue is exceptionally strong in the High yield bonds market as usually there is a narrow market for these issues, partly because some institutional investors often can’t place more than 5% of their total assets in bonds having below investment grade rating.
4. Interest Rate Risk
These bonds often react more than other types of debt instruments to interest rate risk or the risk that the price of the bond will drop when general interest rates rise or vice versa.