Long-term funding: investment-grade vs high-yield issuers
Investment-grade issuers borrow unsecured, for up to 30 years, with few covenants, and most of their yield is the government rate. High-yield issuers pay larger spreads, borrow for shorter periods, often secured, under tight covenants, and use calls and prepayable loans to refinance if their credit improves.
Before this: Repurchase agreements (repos), Bond indentures and covenants
On the exam
- Contrast the long-term funding of investment-grade versus high-yield corporate issuers
Contrast long-term funding of investment-grade and high-yield issuers. Expect a feature-table question (which feature is typical of which), a fallen-angel question, and a maturity-choice question (price, reinvestment or rollover risk).
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What do investment-grade and high-yield issuers have in common?
Both choose a maturity by weighing risk against the yield to maturity. Under normal market conditions, a longer maturity means both a higher government yield and a wider credit spread for the same issuer. Credit quality matters more at longer maturities, because the chance of financial distress grows with time.
- Investor: bond longer than horizon Use it attracted by the higher YTM
- Price risk Use it must sell a shorter-dated bond early at an uncertain price
- Reinvestment risk Use it coupons reinvested at lower rates
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- Issuer: debt shorter than the project Use it attracted by the lower YTM
- Rollover risk Use it must refinance at maturity, maybe at higher rates
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An investor with a 4-year horizon may be drawn to the higher YTM of a 10-year bond. The investor takes price risk , because the bond will have to be sold after four years as a 6-year bond at an uncertain price. It also faces reinvestment risk: coupons may be reinvested at lower rates than the bond pays.
An issuer may be drawn to the lower YTM of a 3-year bond to fund a 6-year plant. It takes on rollover risk: at year 3 it must refinance at whatever rate then applies, possibly a higher one, or find the market closed. The trade-off exists for both types of issuer, but the larger spreads of high-yield debt make it sharper for lower-quality borrowers.
How do their bonds differ?
The differences go well beyond the size of the credit spread.
- Investment grade Memorize rated BBB− or better; strong ability to pay
- Yield Memorize small credit spread, mostly the government yield
- Cash flows Use it bond-like, unlikely to default
- Terms Memorize up to 30 years, staggered; senior unsecured; few covenants
- Analysis Use it ratios and ratings: will the rating change?
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- High yield Memorize rated BB+ or below; more vulnerable
- Yield Memorize large credit spread
- Cash flows Use it equity-like, uncertain
- Terms Memorize 10 years or less; often secured; many covenants; callable
- Analysis Use it probability of default and loss given default
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- Fallen angels Memorize high-yield credit risk with investment-grade bond features
Investment grade
An investment-grade issuer is strong enough to meet its debt payments from operating cash flows, so most of its YTM is the government benchmark yield. Bondholders monitor it lightly, and the issuer can choose maturities freely, usually up to 30 years. The cash flows are bond-like. Typical restrictions are limited to protecting claims on the company’s assets: limits on liens (pledging assets to a third party) and on sale and leaseback.
Investment-grade bonds are standardized, so a frequent issuer often has several senior unsecured general obligation bonds outstanding on similar terms with different maturities. These staggered maturities reduce rollover risk, since only part of the debt comes due at once, and keep the issuer able to borrow more whenever markets are good. Analysts use financial ratios and ratings to judge if and when the issuer’s default probability will change.
A bond's government benchmark yield is 4.00% and its credit spread is 0.90%. Its yield to maturity is closest to:
4.00% + 0.90% = 4.90%
Yield to maturity4.90%
- 4+0.9=
- 4ENTER0.9+
ENTER enter (on the HP, puts the number on the stack)
High yield
A high-yield issuer is more likely to face distress, and a bigger share of its YTM is an issuer-specific spread over the benchmark. Its cash flows are more equity-like because they are uncertain, so analysts focus on the probability of default and the loss given default, and on the protections and secondary sources of repayment.
Investors therefore impose more constraints, written as restrictive covenants in the indenture (or loan agreement). Typical ones limit additional debt, cap the ratio of debt to operating cash flow (such as debt to EBITDA, which is earnings before interest, taxes, depreciation, and amortization), set a floor for interest coverage, and restrict dividends and distributions. High-yield debt is also often secured by specific assets, so that a more likely default does less damage. The result is much less flexibility and market access than investment-grade issuers enjoy.
Maturities are typically 10 years or less, and credit spreads and market availability swing with the economic cycle. Rather than borrowing opportunistically, high-yield issuers often have to restructure debt and renegotiate covenants to benefit from lower borrowing costs.
To keep some flexibility they borrow in leveraged loans with prepayment features, or issue callable bonds. An issuer that expects its creditworthiness to improve likes a call, because the option gains value as its borrowing cost falls. Investors share the price rise as spreads narrow, but the gain is capped at the call price.
What are fallen angels?
Fallen angels are former investment-grade issuers that have been downgraded to high yield. Their risk of distress looks like that of other high-yield issuers, but their outstanding bonds keep investment-grade features: typically non-callable, with few covenants and long maturities. The reason is that the bonds were sold to investment-grade investors when the borrower was highly rated.
After the downgrade, the original investors take losses. Many must sell because the bonds no longer meet the minimum rating in their mandates. The high-yield market is a fraction of the size of the investment-grade market, so forced selling can push prices down sharply.
Go deeper Why staggered maturities reduce refinancing risk
If all of a company’s debt matured in one year, it would have to refinance everything at that year’s market rates, and a closed market would be a crisis. With bonds maturing in 3, 5, 10, 20 and 30 years, only a slice comes due in any one year. A frequent issuer can also pick the good years to borrow more.
Go deeper When is a call worth exercising?
The issuer compares the present value of the interest it would save by refinancing at a lower yield with the call premium it must pay over par. If the savings exceed the premium, calling makes sense. For investors, the call caps the upside, which is why callable bonds are quoted with a yield to worst as well as a yield to maturity. That measure comes later in the topic.
Go deeper Why high-yield analysis looks like equity analysis
When default is a real possibility, bondholders care about what remains in a failure: the assets pledged to them and the order in which claims are paid. That is the way equity holders think about a company’s value too. The topic on corporate credit analysis builds this out.
Memorize this
MemorizeInvestment grade vs high yield
| Investment grade | High yield | |
|---|---|---|
| Share of YTM from spread | small | large |
| Cash flows behave like | bonds | equity |
| Maturity | up to 30 years, staggered | 10 years or less |
| Security | senior unsecured | often secured |
| Covenants | few (liens, sale and leaseback) | many (debt, leverage, coverage, dividends) |
| Analysis | will the rating change? | default probability and loss given default |
| Market access | opportunistic | cyclical; renegotiate to refinance |
| Flexibility | issue when markets are good | callable bonds, prepayable loans |
Memory hook The weaker the credit, the more of the yield is spread and the more the lender writes the rules.
Know it cold Fallen angels keep IG features (long, non-callable, few covenants) with HY risk. Covenants are fixed at issue and do not change on a downgrade.
- Investment grade Memorize rated BBB− or better; strong ability to pay
- Yield Memorize small credit spread, mostly the government yield
- Cash flows Use it bond-like, unlikely to default
- Terms Memorize up to 30 years, staggered; senior unsecured; few covenants
- Analysis Use it ratios and ratings: will the rating change?
-
- High yield Memorize rated BB+ or below; more vulnerable
- Yield Memorize large credit spread
- Cash flows Use it equity-like, uncertain
- Terms Memorize 10 years or less; often secured; many covenants; callable
- Analysis Use it probability of default and loss given default
-
- Fallen angels Memorize high-yield credit risk with investment-grade bond features
- Investor: bond longer than horizon Use it attracted by the higher YTM
- Price risk Use it must sell a shorter-dated bond early at an uncertain price
- Reinvestment risk Use it coupons reinvested at lower rates
-
- Issuer: debt shorter than the project Use it attracted by the lower YTM
- Rollover risk Use it must refinance at maturity, maybe at higher rates
-
Quick example
A BBB bond for which the government yield is 3.20% and the credit spread 1.10% has YTM 4.30%. The spread is 1.10 ÷ 4.30 = 25.6% of the yield. For a B bond with a 4.80% spread, it is 4.80 ÷ 8.00 = 60%.
- 3.2+1.1=1/x×1.1= 0.2558
1/x reciprocal
- 3.2ENTER1.1+1/x1.1× 0.2558
ENTER enter (on the HP, puts the number on the stack) · 1/x reciprocal
How it is asked
-
Which is typical of high yield
Compared with investment-grade bonds, high-yield bonds most likely have ...
Larger spread share, shorter maturities, more covenants, security. Traps: longer maturity; fewer covenants.
-
Downgrade to fallen angel
A BBB issuer falls to BB+. Its existing long bonds ...
Keep IG features (long, non-callable, few covenants). Trap: gain HY covenants or security.
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Maturity mismatch
An issuer funds a 7-year project with 2-year notes because they yield less. Main risk?
Rollover risk. Trap: reinvestment risk (an investor risk).
-
Maturity and yield
For one issuer, how do yield and spread change with longer maturity?
Both higher under normal conditions.
Exam traps
- Saying high-yield bonds have more bond-like cash flows. They are more equity-like.
- Saying fallen angels' bonds have high-yield features. They keep their investment-grade terms.
- Assuming high-yield maturities stretch to 30 years like investment grade. They are typically 10 years or less.
- Calling reinvestment risk an issuer risk. The issuer's maturity risk is rollover risk.
Checkpoint
4 exam-style questions. About 90 seconds each.
1Compared with investment-grade bonds, high-yield bonds most likely have:
2A company rated BBB at issue is downgraded to BB+. Its existing long-term bonds most likely:
3An issuer funds a 7-year project with 2-year notes because they yield less. The main risk it takes on is:
4A seven-year corporate bond yields 6.80% and the government benchmark yield for that maturity is 4.10%. The share of the bond's yield to maturity that comes from the credit spread is closest to:
Key takeaways
- Longer maturity means a higher government yield and a wider credit spread.
- Investment grade: long, unsecured, few covenants, yield mostly the government rate.
- High yield: shorter, often secured, many covenants, yield heavy in spread, callable for flexibility.
- Fallen angels: high-yield risk inside investment-grade documentation.
Quick example
A BBB bond for which the government yield is 3.20% and the credit spread 1.10% has YTM 4.30%. The spread is 1.10 ÷ 4.30 = 25.6% of the yield. For a B bond with a 4.80% spread, it is 4.80 ÷ 8.00 = 60%.
- 3.2+1.1=1/x×1.1= 0.2558
1/x reciprocal
- 3.2ENTER1.1+1/x1.1× 0.2558
ENTER enter (on the HP, puts the number on the stack) · 1/x reciprocal
All Fixed Income formulas, every lesson
Practice exam-style questions on Fixed-Income Markets for Corporate Issuers
Questions about this lesson?
Where this comes back
- Yield and Yield Spread Measures for Floating-Rate Instruments Fixed Income
- Credit Risk Fixed Income
- Credit Analysis for Corporate Issuers Fixed Income
Questions candidates ask
What is the difference between investment-grade and high-yield bonds?
Investment-grade issuers are rated BBB− or better and borrow long term on light terms. High-yield issuers pay bigger spreads, borrow for shorter periods and accept security and tight covenants.
Why do high-yield companies issue callable bonds?
To keep the option of refinancing more cheaply if their credit improves. Investors accept that their price gains are capped at the call price.
What happens to bonds when an issuer becomes a fallen angel?
Their terms do not change, but prices often drop because investors restricted to investment-grade ratings must sell into a much smaller high-yield market.
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