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Define high-yield bonds, then describe the kinds of issuers that sell them and the payment features that are unique to them.

FRM® Part I · Financial Markets and Products · Corporate Bonds · FRM1.FM.17.c

The idea

High-yield (junk) bonds are those rated below investment grade. That means below BBB- at S&P and Fitch, or below Baa3 at Moody's, so BB+ or Ba1 and lower. Typical issuers are young or fast-growing companies without a long record, highly leveraged firms such as leveraged buyout targets, and firms in or emerging from restructuring. Another group is fallen angels, which were investment grade when the bonds were issued and were later downgraded. Payment features unique to the sector help issuers with weak early cash flow. A deferred-coupon bond pays no cash coupon for an initial period and then pays the full coupon. A step-up bond has a coupon that rises on a schedule. A payment-in-kind (PIK) bond pays its coupon in additional bonds, so the debt balance grows. Do not confuse a fallen angel with a rising star, which moves up into investment grade.

Formulas

Face amount of a payment-in-kind bond

face owed = F × (1 + c)ⁿ

F
the original face amount
c
the coupon rate per period, paid in more bonds
n
the number of coupon periods

Each coupon is paid in more bonds that themselves earn interest, so the debt compounds. For semiannual coupons halve the rate and double the periods.

A practice question

From the question bank, with the reason each wrong option is wrong.

In the high-yield market, a fallen angel is:

  1. A bond issued by a young company that has never been rated investment grade.Why not: Describes an original-issue high-yield bond, not a downgraded one.
  2. A bond rated investment grade at issue and later cut to high yield. - correct
  3. A high-yield bond that is upgraded to investment grade.Why not: Describes a rising star, the opposite movement.
  4. A bond whose coupon is paid in additional bonds.Why not: Describes a payment-in-kind bond, a payment feature, not a type of issuer.

A fallen angel starts life as investment grade and drops below BBB-/Baa3. A rising star moves the other way.

A harder one

A high-yield issuer sells 100 face of a payment-in-kind (PIK) bond with an 8% annual coupon, paid entirely in additional bonds, for 3 years. What is the face amount owed at the end of year 3 (before the final redemption)?

  1. 124.00Why not: Uses simple interest; PIK bonds are themselves interest-bearing, so the increases compound.
  2. 100.00Why not: Assumes the coupons are paid in cash and the face amount is unchanged.
  3. 136.05Why not: Compounds for four years instead of three.
  4. 125.97 - correct

Each coupon is paid in more bonds that earn interest, so the balance compounds: 100 x 1.08³ = 125.97.

The hardest tier

A leveraged buyout issuer sells USD 50 million of PIK notes paying 9% per year, with the coupon paid semi-annually in additional notes. What is the face amount outstanding after 2 years?

  1. USD 59.63 million - correct
  2. USD 59.41 millionWhy not: Compounds annually although the notes pay semi-annually.
  3. USD 59.00 millionWhy not: Uses simple interest and ignores compounding.
  4. USD 70.58 millionWhy not: Applies the full annual 9% rate in each of four semi-annual periods.

Semi-annual rate 4.5%, 4 periods: 50 x 1.045^4 = 59.63. The debt grows while no cash is paid, which raises the claim and the credit risk.

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