High Yield Debt

High yield or noninvestment grade corporate bonds are rated below Baa3/BBB– by credit rating agencies. These bonds are also called junk bonds because of their higher perceived credit risk.

Reasons for noninvestment grade ratings may include:

• High leverage.
• Unproven operating history.
• Low or negative free cash flow.
• High sensitivity to business cycles.
• Low confidence in management.
• Unclear competitive advantages.
• Large off-balance-sheet liabilities.
• Industry in decline.

Because high yield bonds have higher default risk than investment grade bonds, credit analysts must pay more attention to loss severity. Special considerations for high yield bonds include their liquidity, financial projections, debt structure, corporate structure, and covenants.

Liquidity. Liquidity or availability of cash is critical for high yield issuers. High yield issuers have limited access to additional borrowings, and available funds tend to be more expensive for high yield issuers. Bad company-specific news and difficult financial market conditions can quickly dry up the liquidity of debt markets. Many high yield issuers are privately owned and cannot access public equity markets for needed funds.

Analysts focus on six sources of liquidity (in order of reliability):

1. Balance sheet cash.
2. Working capital.
3. Operating cash flow (CFO).
4. Bank credit.
5.  Equity issued.
6. Sales of assets.

For a high yield issuer with few or unreliable sources of liquidity, significant amounts of debt coming due within a short time frame may indicate potential default. Running out of cash with no access to external financing to refinance or service existing debt is the primary reason why high yield issuers default. For high yield financial firms that are highly levered and depend on funding long-term assets with short-term liabilities, liquidity is critical.

Financial projections: Projecting future earnings and cash flows, including stress scenarios and accounting for changes in capital expenditures and working capital, are important for revealing potential vulnerabilities to the inability to meet debt payments.

Debt structure:High yield issuers’ capital structures often include different types of debt with several levels of seniority and hence varying levels of potential loss severity. Capital structures typically include secured bank debt, second lien debt, senior unsecured debt, subordinated debt, and preferred stock. Some of these, especially subordinated debt, may be convertible to common shares.

A credit analyst will need to calculate leverage for each level of the debt structure when an issuer has multiple layers of debt with a variety of expected recovery rates.

High yield companies for which secured bank debt is a high proportion of the capital structure are said to be top heavy and have less capacity to borrow from banks in financially stressful periods. Companies that have top-heavy capital structures are more likely to default and have lower recovery rates for unsecured debt issues.

Corporate structure: Many high-yield companies use a holding company structure. A parent company receives dividends from the earnings of subsidiaries as its primary source of operating income. Because of structural subordination, subsidiaries’ dividends paid upstream to a parent company are subordinate to interest payments. These dividends can be insufficient to pay the debt obligations of the parent, thus reducing the recovery rate for debt holders of the parent company.

Despite structural subordination, a parent company’s credit rating may be superior to subsidiaries’ ratings because the parent can benefit from having access to multiple cash flows from diverse subsidiaries.

Some complex corporate structures have intermediate holding companies that carry their own debt and do not own 100% of their subsidiaries’ stock. These companies are typically a result of mergers, acquisitions, or leveraged buyouts.

Default of one subsidiary may not necessarily result in cross default. Analysts need to scrutinize bonds’ indentures and other legal documents to fully understand the impact of complex corporate structures. To analyze these companies, analysts should calculate leverage ratios at each level of debt issuance and on a consolidated basis.

Covenants: Important covenants for high yield debt include:

• Change of control put: This covenant gives debt holders the right to require the issuer to buy back debt (typically for par value or a value slightly above par) in the event of an acquisition. For investment grade bonds, a change of control put typically applies only if an acquisition of the borrower results in a rating downgrade to below investment grade.
• Restricted payments: The covenant protects lenders by limiting the amount of cash that may be paid to equity holders.
• Limitations on liens: The covenant limits the amount of secured debt that a borrower can carry. Unsecured debt holders prefer the issuer to have less secured debt, which increases the recovery amount available to them in the event of default.
• Restricted versus unrestricted subsidiaries: Issuers can classify subsidiaries as restricted or unrestricted. Restricted subsidiaries’ cash flows and assets can be used to service the debt of the parent holding company. This benefits creditors of holding companies because their debt is pari passu with the debt of restricted subsidiaries, rather than structurally subordinated. Restricted subsidiaries are typically the holding company’s larger subsidiaries that have significant assets. Tax and regulatory issues can factor into the classification of subsidiary’s restriction status. A subsidiary’s restriction status is found in the bond indenture.

Bank covenants are often more restrictive than bond covenants, and when covenants are violated, banks can block additional loans until the violation is corrected. If a violation is not remedied, banks can trigger a default by accelerating the full repayment of a loan.

In terms of the factors that affect their return, high yield bonds may be viewed as a hybrid of investment grade bonds and equity. Compared to investment grade bonds, high yield bonds show greater price and spread volatility and are more highly correlated with the equity market.

High yield analysis can include some of the same techniques as equity market analysis, such as enterprise value. Enterprise value (EV) is equity market capitalization plus total debt minus excess cash. For high yield companies that are not publicly traded, comparable public company equity data can be used to estimate EV. Enterprise value analysis can indicate a firm’s potential for additional leverage, or the potential credit damage that might result from a leveraged buyout. An analyst can compare firms based on the differences between their EV/EBITDA and debt/EBITDA ratios. Firms with a wider difference between these ratios have greater equity relative to their debt and therefore have less credit risk.