QFIP-135 - High-Yield Bond Market Primer

Question 1

Define high yield bonds and explain their common features.

Answer 1

1. High yield bonds are non-investment grade bonds.
2. They are generally higher risk
3. Offer higher interest rates
4. Usually issued by companies seeking money for growth or other cash flow purposes
5. They usually have investor friendly covenants to attract buyers.

Question 2

What are some names for speculative grade bonds?

Answer 2

• Junk bonds
• high yield bonds
• non-investment grade bonds

Question 3

What are the cutoff ratings thresholds for speculative grade bonds?

Answer 3

• S&P/Fitch: below BBB-
• Moody’s: below Baa3

Question 4

Describe the Three Main Issuance Steps of High Yield Bonds

Answer 4

1. Draft the offering proposal and negotiate conditions
2. Allocate securities to bondholders
3. Bonds are available for purchase/sale in the secondary market

Question 5

Describe the Two Common Features for High Yield Bonds

Answer 5

1. Coupon - usually semiannual fixed rate, coupon rates can range anywhere from 0% to over 10%
2. Maturity - when the full principal is due, averaging 7-10 years for most high yield bonds

Question 6

Issuers of High-Yield Bonds

Answer 6

1. Fallen Angels
   
   • Companies that used to carry higher rating but have since been downgraded.
   • They issue bonds to improve their balance sheet for an eventual upgrade
2. Start-up companies
   
   • New companies that need funding to grow its operations.
   • Do not have an operational history strong enough to achieve investment grade ratings.
3. Leveraged buyouts (LBOs)
   
   • Use high yield bond to fund purchase of companies and to pay special dividends
4. Other capital intensive businesses, such as oil prospecting
   
   • Use high yield bond to fund capital

Question 7

Define Fallen Angels (issuers of high yield bonds)

Answer 7

Entities that once carried higher ratings before falling on hard times

Question 8

Define call protection (High Yield Bonds)

Answer 8

limits the ability of the issuer to call the paper for redemption

Question 9

Define call premiums (High Yield Bonds)

Answer 9

Come into effect AFTER the period of call protection ends.

• As an example, the premium on the first call date might start at par plus 50% of coupon and then decline linearly to par each year as maturity is approached.

It’s also the dollar amount over the par value of a callable debt security that is given to holders when the security is redeemed early by the issuer.

Also called the redemption premium. In options terminology, the call premium is the amount that the purchaser of a call option must pay to the writer.

Question 10

Define bullet structure for bonds. (High Yield)

Answer 10

• Ensures full-time call protection, meaning the bond cannot be called on by the company
• Commands lower bond yields

Question 11

Define make-whole call (High Yield)

Answer 11

Gives a stated premium that will be used if a company desires to retire
debt early

Question 12

Define put provisions (High Yield Bonds)

Answer 12

Allow bondholder to accelerate repayment at a defined price due to certain trigger events

Question 13

Define Equity clawbacks (High Yield Bonds)

Answer 13

Allow the issuer to refinance a certain amount of outstanding bonds with proceeds from an equity offering.

Question 14

Define Equity warrants (High Yield)

Answer 14

Each bond carries a defined number of warrants to purchase equity in the company at a later date

Question 15

Define Escrow accounts (High Yield Bonds)

Answer 15

Account created to cover a defined number of interest payments

Question 16

Bond Indenture (High Yield)

Answer 16

Includes the description of covenants

Question 17

Define YTM (High Yield Bonds)

Answer 17

The interest rate that equates the PV of cash flows with the market price

Question 18

Shortcoming of YTM (High Yield)

Answer 18

Assumes the bond will be held to maturity and all interim cash flows will be reinvested at a rate equal to the YTM (shortcoming)

Question 19

Define Yield to Call (High Yield Bonds)

Answer 19

Yield on a bond assuming that the bond is redeemed by the issuer at the first call date

Question 20

Define Yield to Worst (High Yield Bonds)

Answer 20

The lowest yield generated over all possible stated call dates prior to maturity

Question 21

Define Current Yield (High Yield Bonds)

Answer 21

= Annual Coupon Interest divided by Market Price

Question 22

High-Yield Bonds Steps for Typical Underwriting Process

Answer 22

1. Prepare the prospectus
2. Negotiate terms with investors
3. Syndication and allocation

Question 23

Describe the Three Types of Syndication of High Yield Bonds

Answer 23

1. Underwritten
2. Bought deal
3. Back-stop deal

Question 24

Underwritten Syndication Type for High Yield Bonds

Answer 24

Best offerts and no legal obligation if demands do not fully meet total offering (most common)

Question 25

Bought Deal Syndication Type for High Yield Bonds

Answer 25

Transaction is fully guaranteed/purchased by underwriter at an undisclosed rate for a day or less timing

• Subject to market risk for underwriter
• No Execution risk for issuer

Question 26

Back-Stop Deal Syndication Type for High Yield Bonds

Answer 26

Underwriter agrees to purchase the deal at a maximum interest rate for a brief, but well-defined period of time (usually up to 1 week)

• Similar to Bough deal but longer timeframe