Corporate debt is divided into investment-grade and high-yield on the basis of the credit risk associated with the issuer. Credit rating agencies issue ratings to corporations and debt issuance on the basis of associated credit risk. Rating agencies arrive at the ratings based on the financial strength, operating performance, and future prospects of the corporate. While rating a particular debt issue, rating agencies look for available guarantees, seniority of debt, et cetera. Corporations with higher earnings, limited debt exposure, and the potential to receive better credit ratings compared to corporations with a stringent cash position and inability to service their debts on time.
Investment-grade versus non–investment-grade
Debt securities issued by corporations rated BBB- and above by S&P or Fitch or Baa3 and above by Moody’s are considered investment-grade, while those that receive a lower rating than that fall in the non–investment-grade or junk category. Non–investment-grade debt is further sub- divided into leveraged loans, which are loans issued by corporations rated BB+ or below and paying an interest rate of more than LIBOR + 125 basis points, and high yield bonds.
Investment-grade corporate bonds
These bonds are issued by long-established companies with strong balance sheets and are rated “investment-grade” since they have a lower chance of defaulting on their debt. Bonds that are rated BBB- and above by S&P, and Baa3 and above by Moody’s, fall into this category. Investment-grade bonds are of medium-to-highest credit quality, with AAA or Aaa being the highest rating, indicating the highest safety. Very few corporations—including Johnson & Johnson (JNJ) and Microsoft (MSFT)—are rated AAA or Aaa by rating agencies.
ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) invest primarily in investment-grade corporate bonds, while ETFs such as the Vanguard Total Bond Market ETF (BND) and the iShares Core Total U.S. Bond Market ETF (AGG) invest in the entire investment-grade bond market, including Treasuries.
High-yield bond or junk bonds are bonds issued by companies with a below–investment-grade credit rating of BB+ or lower. High-yield bonds pay a higher yield than Treasury and investment-grade corporate bonds as an additional credit risk premium. These are generally issued for leveraged buyouts and other corporate takeovers.
These are syndicated loans extended to companies or individuals that already have considerable amounts of debt. On the surface, leveraged loans look similar to high-yield bonds, but both these asset classes differ significantly. Leveraged loans have limited interest rate risk because they have a floating rate feature. As leveraged loans are pegged to a benchmark, usually LIBOR, these are protected from the interest rate risk prevailing in the market to some extent.
Both risk and returns in the case of junk debt are higher compared to investment-grade debt on account of higher credit risk. Investors choose between these two on the basis of their individual risk appetite and return expectations. Investors of a more risk-averse temperament seeking to park their funds in safer investments prefer investment-grade bonds, while risk-taking investors often choose high-yield securities in their search for a higher return.
Between high-yield bonds and leveraged loans, individual investors often decide to invest on the basis of differences in interest rate, security, maturity, covenants, and amortization. However, both leveraged loans and high yield bonds have a similar investor base, with the most common investor base between both asset classes being institutional investors, which include mutual funds, finance companies, and other specialized investors.
Mutual funds are by far the largest investors in both leveraged loans and high yields bonds. Mutual funds represent approximately 35% of the total high yield investor pool, followed by pension funds, which represent 25% of the high yield investor market.
The next parts of this series analyze new issuance and fund flows in high-yield bonds and leveraged loans.