13.10 High Yield Securities: Junk Bonds and Other Speculative Securities
The phrase “junk bonds” is a bit unfair because no rational person would throw out something of value, as s/he might do with something that is truly “junk.” Even bonds in default may have some monetary value greater than zero. High yield securities merely have lower credit ratings and therefore higher yields.
In 1978, there was less than $10 billion worth of junk bonds outstanding – in terms of aggregate face value. In 2006, this figure exceeded $1 trillion! Whereas in the past, most issues consisted of “fallen angels,” or securities issued by corporations that once enjoyed investment grade credit ratings, but fell on hard times, today most junk bonds are originally issued as high yield securities. Further, emerging markets the world over add to new issuance; the prospective high returns attract many investors.
This low-grade security growth has precipitated two other interesting phenomena: the markets for “syndicated loans” and “leveraged loans.” Syndicated loans are package deals provided often by investment banks rather than commercial banks, which traditionally have made such large loans. These loans are aggregated and packaged, and then “securitized,” that is, sold as securities. Many of these bonds went bad in the 2007-2008 Banking Crisis. A leveraged loan is one which is made to companies that already may have low-grade bonds outstanding; such loans are then often syndicated.
Distressed debt consists of junk bonds whose companies are in such dire straits that their yields are substantially higher than the risk-free rate. “Defaulted debt” represents corporations who have defaulted on their bond issues. A “default” may consist merely of the violation of its bank lending agreement or its bond’s indenture, i.e., the legal document, which sets forth all the terms of the loan, and which may require that the issuer maintain its financial ratios within certain parameters. It may also result, more seriously, from a late or missed interest payment.
Vulture funds are often operated by hedge funds and attempt to profit off the remains of bankrupt corporations by purchasing the defaulted bonds and repossessing the company’s assets. The vultures then sell off the assets at a profit.
Typically, default rates increase as the economy enters a recession. Default rates are sometimes defined as the dollar amount of defaults relative to the aggregate amounts outstanding. The credit rating agencies define default rates in connection with the number of high-yield issuers who default.