Special considerations for high-yield corporate bonds, Financial Management

Assignment Help:

High-yield bonds are issued by organizations that do not qualify for "investment-grade" ratings by any one of the leading credit rating agencies - Moody's Investors Service, Standard & Poor's Ratings Services and Fitch Ratings. Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuer's ability to pay interest and principal as scheduled. Those issuers with a greater risk of default - not paying interest or principal in a timely manner - are rated below investment grade. These issuers must pay a higher interest rate to attract investors to buy their bonds and compensate them for the risks associated with investing in organizations of lower credit quality.

While analyzing a high-yield bond, analysts should study about the debt structure, corporate structure and covenant.

1. Analysis of Debt Structure: Debt structure of a high-yield issuer mainly includes bank debt, brokers loans or bridge loans, reset loans, senior debt, senior subordinate debt and subordinate debt. 

First, let us look into bank loan. High-yield issuer would rely more on bank loans because its low credit rating would make it a less attractive investment for creditors. Therefore, bank loan constitutes a major part of a firm's debt. The bank debt, which is short-term and secured debts, would give the holders priority over other debt holders on the assets of the firm. When a firm is heavily financed by bank debt, floating interest rates may pose severe cash flow problems to the issuer.  One more issue to be considered is how the issuer would pay back the bank loan. There are usually three options available for the issuer, (i). Repayment from operating cash flow (ii). Refinancing and (iii) Sale of assets. Analysts must be careful in examining the source of payment as any discrepancies would affect the ability of the issuer to repay the debt.

When a high-yield issuer turns to broker loans or reset loan for financing, it is of concern to the bond holders. As the coupon rate of the reset note would be changed periodically (so that the security would trade at a price premium above the par value), an analyst should carefully examine the impact of rising interest rates as it could lead to higher borrowing cost.

While analyzing debt structure of a high-yield issuer, the analyst should also look into the fact, whether the issuer has any deferred coupon bonds. A deferred coupon bond, such as a zero coupon bond, is a debt instrument that pays no interest until a date specified in the future. A deferred interest payment implies that the future cash flows would be affected by this obligation. Analysts should carefully examine the effect of this obligation while analyzing a high yield corporate bond.

2. Analysis of Corporate Structure: When high-yield issuers have a holding company structure, an analyst should also look into the operation of the subsidiaries. The analyst should understand the corporate structure of the firm so as to understand the effect of cash flow between the subsidiaries and the parent company. Understanding this is important to analyze the sources of finance for the parent company to pay its creditors. Examining the debt structure of the subsidiary helps the analyst in finding out how much the subsidiaries would be able to contribute to the parent company in paying off its creditors.

3. Analysis of Covenants: An analyst should go for a detailed analysis of the covenants in the bond indenture as it provides insight into the company's strategy. Any loopholes in covenants provide clues about the intentions of the management.

4. Equity Analysis Approach: Analysis of a high-yield bond from an equity analyst's perspective is strongly recommended by some portfolio managers. As per Stephen Esser -

Using an equity approach, or at least considering the hybrid nature of
high-yield debt, can either validate or contradict the results of traditional credit analysis, causing the analyst to dig further.

He further states that for those who work with investing in high-yield bonds, whether issued by public or private companies, dynamic, equity-oriented analysis is invaluable. If analysts think about whether they would want to buy a particular high-yield company's stock and what will happen to the future equity value of that company, they have a useful approach because, as equity values go up, so does the equity cushion beneath the company's debt. All else being equal, the bonds then become better credits and should go up in value relative to competing bond investments.

5. Default Rates on High Yield Securities: There is a difference between default rate and loss rate. Default rate is the proportion of companies defaulting per year. But not all companies that default go bankrupt. The recovery rate is the proportion of defaulting companies that do not eventually go bankrupt. High yield securities are considered to have speculative characteristics. They may have a greater risk of default or may already be in default because of the issuer's low creditworthiness. The default rate on high yield securities is likely to be higher during economic recessions or periods of high interest rates. During the recession of 1990, the default rate was 10 percent, but with growing economy, the default rates have come down. According Moody's FMR Co ( MARE) report, the average historical default rate for September 30, 1986 to February 28, 2007 is 5%.


Related Discussions:- Special considerations for high-yield corporate bonds

What happens when a bank charges discount interest on a loan, What happens ...

What happens when a bank charges discount interest on a loan? While a bank charges discount interest on a loan the required interest payment is subtracted from the loan carries o

What do you signify by investment decisions, Q. What do you signify by Inve...

Q. What do you signify by Investment Decisions? Investment Decision: - The most significant function of financial management isn't only the procurement of external funds for th

Determine the valuing equity securities, Determine the Valuing Equity Secur...

Determine the Valuing Equity Securities Unlike debt and money market instruments, equity instruments represent ownership interest in the company. As owners should put in their

Brief the term directors and managers, Directors and managers While dir...

Directors and managers While directors and managers are in concentrate attempting to promote and balance the interests of shareholders and other stakeholders it has been argued

Forward contracts, Forward Contracts: The origin of forward contracts i...

Forward Contracts: The origin of forward contracts is lost in history. Some authors suggest that, it was India where these contracts took birth, while some others suggest that

Determine the example of future value of an annuity, Determine the example ...

Determine the example of Future Value of an Annuity An annual payment of 7000 $ is invested at 5% per annum compounded yearly. What will be the amount after 20 years? Solut

What is the difference between ias 14 and ifrs 8, Differences between IAS 1...

Differences between IAS 14 and IFRS 8 IFRS 8 requires identification of operating segments based on internal reports which are regularly reviewed by management for decision

Advanced financial management, QUESTION 1 [25 marks] Xelo Ltd, whose curren...

QUESTION 1 [25 marks] Xelo Ltd, whose current sales consist of fixed operating costs of R140 000 and variable operating costs equal to 22% of sales, has made the following two sale

Stock exchange, Working and function of stock exchange

Working and function of stock exchange

Coefficient of determination, Coefficient of Determination As before, ...

Coefficient of Determination As before, Where, We can show that TSS = RSS + ESS We can also show that F = is an F distr

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd