High Yield Debt. Bagaria Rajay

      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.