Long-term funding: investment-grade vs high-yield issuers

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.

$$\text{YTM} = y_{\text{gov}} + s_{\text{credit}}$$

Maturity choicea longer bond has a higher government yield and a wider spread

• 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

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.

Corporate long-term debtfeatures follow the issuer credit quality

• 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

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.

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.