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Chapter 1 lays the groundwork necessary for understanding the U.S. corporate high yield asset class. It starts by explaining what high yield debt is and how it compares to investment grade debt, the two broad fixed income categories. The chapter then covers the importance of credit ratings before providing a short history on how the modern day, high yield market evolved. This history tells a story of market growth that was not always sound, epitomized by the early 1990s “junk bond” bubble. However, the high yield industry has grown from its experiences. Improved underwriting standards, regulatory scrutiny, and greater investor protections ultimately fostered more sustainable growth manifest in today's $2.5 trillion market. To note, terms that might be confusing or are industry jargon are highlighted in italics and included in the Glossary.

1.1 WHAT IS HIGH YIELD DEBT?

High yield debt, often referred to simply as high yield, is debt rated below investment grade by major rating agencies such as Moody's Investor Services, Standard & Poor's (S&P), or Fitch Ratings. The highest rated debt is labeled investment grade by the rating agencies and has low risk of default or loss. This ratings category includes U.S. government bonds and the debt of large public companies such as General Electric, Microsoft, and ExxonMobil. Rating agencies label debt with below BBB-/Baa3 ratings as below investment grade or speculative grade, which constitute the high yield market. As the name “high yield” suggests, this category of debt provides a high rate of return to compensate for greater credit risk, or the possibility that the debt does not get repaid in full.

Leo Tolstoy's famous observation that “happy families are all alike; every unhappy family is unhappy in its own way” aptly describes the differences between investment grade and below investment grade borrowers as well. Investment grade borrowers are like happy families, enjoying access to the capital markets at attractive rates. For example, Apple (Aa1/AA+ rated) raised $5.5 billion in 2013 of 10-year debt at 2.4 %, a rate similar to what the U.S. government pays. The risk of default for investment grade issuers is considered negligible; therefore, the borrowing rates are similar and more affected by the yield curve – or interest rates of government debt with different maturities – which serves as a benchmark for all debt. Though the prospects for investment grade companies' stock differs, their debt is generally well insulated from growth-related risks. In this way, the “happy families” are all alike.

High yield borrowers are more like unhappy families borrowing at expensive rates, each for its own reason. The high yield issuer base is broad; it includes countries, municipalities and corporations such as Costa Rica, Detroit and Sprint. Each high yield issuer has unique challenges and opportunities. Unlike investment grade companies, growth prospects matter more because these entities are more heavily indebted. As Moody's and S&P ratings migrate to lower categories such as Caa1/CCC+, the potential for default and loss amplifies. What binds high yield issuers into one asset class is simply a rating designation: below investment grade. But high yield issuers, unlike investment grade companies, carry more idiosyncratic risks, similar to stocks, and must pay higher interest rates on their debt as a result. In Tolstoy's words – and the debt markets – high yield issuers are the unhappy families, with each being unhappy in its own way.

Table 1.1 details the highest to lowest ratings provided by Moody's and S&P. Though each rating agency uses a different methodology to estimate and categorize credit risk, they produce comparable metrics. For example, a Baa2 rating by Moody's is similar to a BBB rating by S&P. This is shown below. The notching can also be viewed comparably, where a “1” from Moody's is similar to a “+” from S&P. Notching provides an added degree of segmentation which shows how close an issuer is to the next ratings tier.

TABLE 1.1 Moody's and S&P Ratings Categories

Regarding the ratings chart, it's interesting to note that high yield is a somewhat arbitrary designation. The ratings agencies don't provide clear guidance on why BBB-/Baa3 serves as the demarcation line between what they consider investment grade and below investment grade. The decision, however, made many decades ago, now broadly classifies the entire fixed income market, which in the United States is estimated at over $40 trillion.5 Today, any outstanding debt obligation – whether it is issued by a company, country, municipality, or even a structured finance vehicle – can be considered investment grade or below investment grade risk.

1.2 THE IMPORTANCE OF CREDIT RATINGS

Credit ratings are important to high yield investors and issuers for a few reasons. First, high yield debt investors generally require issuers to obtain credit ratings from two agencies on any debt offering. Although investors rely on their own business's due diligence – or evaluation of the issuer – when making investment decisions, the ratings still have an impact on the investment decision. This is because many high yield investors have investment mandates shaped by ratings. For example, a certain type of loan investor may only be able to buy a limited number of CCC rated credits, irrespective of what they think of the risk-return. Also, many buyers utilize lower cost borrowings to make investments and seek to profit from the spread. Ratings can affect the amount of financing available or regulatory capital that must be set aside for high yield investments. If a lower rating makes a debt issue more expensive to purchase with financing, investors seek compensation for this cost through a higher interest rate or yield to make the investment sufficiently profitable. It therefore goes without saying that lower ratings result in higher interest costs to issuers.

But the two broad ratings categories – investment grade or below investment grade – when taken literally are actually misleading. Rating agencies in fact have no interest in opining on whether a debt obligation is investment-worthy or not. Rather, the ratings of an issuer or its debt instrument serve only as a third-party assessment of the creditworthiness of the issuer and its ability to meet its debt obligations as they come due. Whether one chooses to buy or sell a debt instrument depends less on whether it is deemed investment or below investment grade and more on whether the price and yield compensate for the risk of loss. Further, credit rating agencies' estimates sometimes bear little relationship to reality. In 2008 for example, the rating agencies grossly underestimated the risks of numerous credit investments that had sub-prime mortgage exposure. Even though the rating agencies are not perfect, they still play an important role in the fixed income industry by constituting a third-party assessment of risk. Ratings can be relied upon for their independence and absence of conflict.

Something to keep in mind is that ratings can be upgraded or downgraded, which means they can change over time with credit developments and periodic ratings review by credit rating agencies. Some high yield issuers eventually have debt that is upgraded to investment grade. When ratings are downgraded from investment grade to below investment grade as they were for Ford and GM in 2005, it causes a turnover in the investor base. Initial investors who prefer, or can only hold, higher quality investment grade issues sell their positions, usually at a loss. New investors, with different investment mandates or who believe the return potential at a lower purchase price now compensates for the risk, step in. Trading in the debt of these types of issues is exactly how the modern high yield market got its start.

1.3 THE ORIGINS OF HIGH YIELD

Strictly speaking, the high yield market took shape in the early 1900s when major rating agencies began providing ratings on government, municipal, and corporate debt. After all, high yield – as it's defined – can only exist with ratings. In practice, however, speculative grade debt existed well before the rating agencies. It was used to finance important modern world developments such as early sea exploration, railroads, banks, and steel companies. Even the United States borrowed heavily from the Netherlands and France in the 1780s shortly after its founding in a way similar to emerging market countries borrowing from the developed countries of today. The potential risks of lending to a newly formed country made this debt akin to what we now consider speculative grade debt.

Speculative grade debt is a natural component of the capital markets system. Similar to how a happy family might become unhappy (e.g., Mom loses her job, Dad becomes ill), creditworthy issuers sometimes hit hard times; and the unthinkable happens – an issuer loses its investment grade rating. During the Great Depression, for example, many investment grade issuers had their debt downgraded to speculative grade status as their financial health and prospects deteriorated.

But the nature of high yield debt has changed in the past four decades. Up until the 1970s, the high yield universe consisted mostly of companies whose debt had been downgraded to below investment grade ratings or so-called fallen angels. Fallen angels include retailers like JCPenney who once prospered and raised investment grade debt to facilitate rapid expansion. As the prospects of these businesses changed and their performance declined, their debt was downgraded, eventually to high yield or “junk” status. When investment grade debt becomes high yield, it carries a low interest rate but trades at a steep price discount. An example would be a 3 % bond trading at a price of 70 %. What this means is that an investor can buy a $1,000 bond for $700. The $300 discount provides additional compensation, or yield, to account for the higher risk of loss that now exists. For example, if this 3 % bond had five years remaining and was paid in full at maturity, it would offer an 11 % yield. This yield can be computed using an internal rate of return calculation assuming an initial cash outflow of $700 followed by $30 per annum of interest income (3 % of $1,000) for five years and then $1,000 of principal return at maturity (in year five).

The modern high yield market obtained its start through the trading of fallen angel debt. One investment banker largely credited for developing this market is Michael Milken. Working for the investment bank Drexel Burnham Lambert, Milken was an early advocate of speculative grade bonds. Drawing from the research of Braddock Hickman, an economist and former Federal Reserve Bank president who published studies on the performance of debt of varying quality, Milken believed that the yields of fallen angel debt often over-compensated for the risk of default loss and that this less understood category of debt provided attractive opportunities for investment. Milken's success in cultivating demand for high yield bonds ultimately opened a primary market for an entirely new type of high yield issuer, one that was deliberately high yield rather than the result of a downgrade.

A primary market refers to the market for new issues and stands in contrast to the secondary market, or market for existing debt. The significance of a high yield primary market was that the issuers were not only composed of fallen angels. They included companies that made a corporate finance decision to raise significant quantities of debt with full knowledge that doing so would result in their debt being classified as high yield. To provide some context, these companies might willingly issue debt with an 11 % interest rate. The issuers that sought to do this were not necessarily companies that longed for their best days; they included companies that were more entrepreneurial with growth prospects that high yield capital might unlock.

Early issuers of high yield included Texas International, an energy company engaged in exploration and development whose story is documented in the book by Harlan Platt, The First Junk Bond.6 It also included companies like McCaw Cellular and Viacom, which had tremendous growth opportunities that were capital intensive to fund. High yield debt provided a means of financing this growth, often led by innovative entrepreneurs who built large successful enterprises. Some of these companies, like Viacom, eventually became investment grade, as their investments paid off. Others, like McCaw Cellular, were sold to strategic or financial buyers in successful transactions.

In opening a primary market for speculative grade issuers, Drexel laid the groundwork for a high yield market that would have profound implications for companies, municipalities, and countries. For corporations who previously either maximized low-cost borrowings or financed operations with high-cost equity, high yield provided a third option, a source of capital between bank or bond borrowings and equity. Although equity capital does not have a stated cost like debt does, the cost of equity is the expected return it provides. For example, many investors expect to generate 10–20 % returns on equity over time. Therefore, high yield, which usually carries a 4–12 % rate, could present an attractive option relative to equity. As an added benefit, interest on the debt is for the most part tax-deductible and thereby lowers the effective cost of borrowings for taxpaying issuers.