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The corporate bond market is divided into two broad categories: the high grade market and the high yield market. The key difference between the two are the ratings of the bonds issued. High grade refers to the universe of corporate bonds rated BBB- and above (i.e. investment grade) while high yield refers to bonds rated BB+ and below (sub-investment grade or “junk” bonds).
Ratings are driven by several factors related to the issuing company. Generally, companies receive sub-investment grade ratings due to several factors, including: riskier final metrics, adverse industry dynamics, company specific metrics, and aggressive financial policy.
Financial metrics usually fall in two main categories, leverage ratios and coverage ratios. Leverage ratios measure how much debt a company has relative to its cash flow generation ability. The most common ratios used are Total Debt / EBITDA1 (referred to as total leverage or gross leverage) and Net Debt / EBITDA (referred to as net leverage), though there are other ratios used depending on the industry, such as Debt / Free Cash Flows or Net Debt / Retained Cash Flows. To be investment grade worthy, companies usually need to have total leverage values below 2.0x.
The relevant dynamics vary by industry and tend to be qualitative in nature. The degree of competition and level of fragmentation help gauge how hard it is for a company to compete and take market share from other players. Cyclicality refers to the susceptibility of the industry to thrive and bust depending on the economic cycle or other industry specific cycles (e.g. the automobile industry is highly cyclical). Capital needs measure how large of an investment a company needs to carry out its business; whether it is heavily investing in plants and machinery (e.g. mining or chemical companies) or investing in retail space or technology. Higher capital needs uses up more cash flows that could be used to service debt instead.
Company specific metrics may be qualitative or quantitative in nature. Some key metrics include: market position and percent market share, scale of operations (total revenues or EBITDA), volatility of earnings and diversification of suppliers, production and end markets.
Financial policy looks at the company’s track record in managing the company’s capitalization. It checks how well the company balances the interests of the shareholders and the credit lenders. Private equity owned companies generally have policies that favor the shareholders and would therefore score low in this category. Companies paying out debt-funded dividends or companies with performing frequent debt funded acquisitions would be considered aggressive.
Given the above characteristics, high yield bonds are inherently riskier than high grade bonds and therefore pay higher coupons to compensate the investor for the higher risk. To protect bondholders, high yield bonds carry more stringent restrictions on the amount of additional debt and the required coverage ratios the company must keep when incurring new debt. These restrictions are called covenants.
Some well known high yield bond ETFs include HYG, JNK and PHB, each tracking their own benchmark of the most liquid high yield bonds in the USD market. On the high grade side, the largest ETF is iShares LQD. Additionally, since longer maturity bonds are more sensitive to interest rate variations (known as higher duration risk), there are also several options available based on maturity: CSJ (1-3 years), VCSH(1-5 years) and CIU (1-10 years).
© 2013 Market Realist, Inc.