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| About HY Bonds | |||||||||||||||||||||||||||||||||||||||||
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High-Yield Bond Primer
High Yield Bond Market High-yield bonds are a newer and unique asset class that is still unfamiliar to many investors. Before making an investment in this type of security, we recommend that you read this brief introductory explanation of high-yield bonds and the high-yield bond market to gain some understanding of the securities and some of the terminology used by bond investors. The U.S. high-yield bond market was a specialty niche market prior to 1980, but has grown very rapidly during the past 25 years. At the end of 2006 it represented approximately $1 trillion of bonds from over 1,000 different issuers. The market has expanded in the past quarter-century because high-yield bonds offer tax-favored financing for corporations (bond interest payments are tax-deductible to corporations while stock dividends are not), and because the unique performance characteristics of high-yield bonds make them appealing to many investors. High-yield bonds are typically issued by: 1) Newer, emerging companies raising money for expansion 2) Older companies which have weak balance sheets and/or weak profits 3) Companies taking on large debts for acquisitions or leveraged buyouts In some cases, formerly investment-grade bonds are downgraded to junk status when a blue-chip company has persistently poor operating results or suffers a business setback. The companies in this segment of the high-yield bond market are known as “fallen angels”. Fallen angels constituted the bulk of the high-yield bond market prior to 1980. New bond issues are sold by bond underwriters in the “primary market” directly to institutional investors--mutual funds, insurance companies, hedge funds and pension funds. New issues are typically sold at their “face value”, or principal amount, which is usually $1,000 per bond. Older bonds are traded among bond dealers and investors in the “secondary market”. Bonds in the secondary market can trade at prices above or below face value. Bonds are quoted as a percentage of face value. Thus, a bond priced at 82 is selling for 82% of its face amount, or $820 per bond. Like any market, the high-yield bond market is influenced by the levels of supply and demand. New issues represent the market’s “supply”. Investor purchases of bonds represent market “demand”. Supply and demand will fluctuate based on many factors. All types of bonds are priced based on 1) their perceived risk level, and 2) the general level of interest rates. It is important to know that bond prices will decline as interest rates rise, and bond prices will climb as interest rates fall. A bond with an 8% interest payment (or “coupon”) will trade below face value when rates move up to 10%, but will trade above face value when rates go down to 6%. Bond coupons are generally fixed. Therefore, changes in the level of interest rates will cause secondary market bond prices to change. Some bonds issues have floating rate coupon features to reduce their price fluctuations caused by changes in interest rates. The other market price determinant--perceived risk level--is the more important influence on the values of high-yield bonds. High-yield bonds are issued by riskier companies that have a dramatically higher rate of failure than investment-grade corporations, and investors are quite aware of the higher risk. The fluctuations of high-yield bond prices are greater than the fluctuations of investment-grade bond prices because high-yield bond issuers are weaker and less predictable than investment-grade companies. It is important to know that, all else being equal, high-yield bond prices will decline as perceived credit risk rises, and high-yield bond prices will climb as perceived credit risk falls. A bond’s credit quality is indicated by its credit rating. The three major credit rating agencies (Moody’s, Standard & Poors, and Fitch) assign ratings to bonds based on their likelihood of default. The agencies define any reduced, late, or missed payment as a default by the issuer. Defaults will often cause a bankruptcy filing by the issuer. A table of credit rating definitions is provided below for your information. Bonds rated Baa or BBB and above are considered investment-grade securities and rarely have defaults. Bonds rated Ba or BB and below are high-yield securities, or “junk bonds”, and generally have default rates in a range of 2-10% per year. Ratings of Long-Term Corporate Debt Securities
High-yield bonds are typically issued with a maturity of ten years. It is a standard bond market practice to price bonds with a “spread” over the comparable Treasury note maturity. This spread is measured in “basis points”. Each basis point is 1/100 of a percentage point. In other words, a spread of two percentage points is described as 200 basis points. A bond with three years until maturity has a yield “spread” measured against the three-year Treasury note. A new bond issue with a ten-year maturity is measured against the ten-year Treasury note. While spreads can change very dramatically with market fluctuations, high-yield bonds have historically fluctuated around a spread of approximately 450 basis points over Treasury securities. This spread is mostly to compensate for the risk of default losses, but also partly to compensate for the lack of liquidity in the high-yield bond market compared to the Treasury market. High-yield bond issues typically have provisions to be “called” after five years. This means that the issuer has the right to redeem the bonds prior to their stated maturity by paying a specified call price equal to or exceeding face value. The issuer’s option to call a bond makes the true redemption date of the bond uncertain. Therefore, bond spreads are conservatively stated using a “yield to worst” calculation, which is the bond’s overall yield calculated to its least favorable possible redemption date. Yield to worst is the lowest yield that a bondholder would receive to redemption or maturity. Occasionally a company is unable to pay its interest or principal payments when due. Most often, the company will file for bankruptcy. This is the major risk of investing in high-yield bonds—a default loss. Since 1986, according to Moody’s, the median annual default rate in the high-yield bond market has been approximately 5%. While defaults are costly, bondholders will typically recover a portion of their investment even in a bankruptcy situation. The historic average default loss is approximately 60% of face value. Therefore high-yield bond returns have been reduced, on average, by approximately 3% per year (60% of 5%) due to default losses. To compensate for these portfolio losses, high-yield bonds pay higher interest rates than investment-grade bonds. Not all corporate bonds have the same risks. Corporate bonds are ranked by seniority within the particular structure of the company’s liabilities. This is very important when calculating the size of a potential default loss. Bonds can be “senior” or “subordinated”, and can be “secured” by assets or unsecured. Bonds that are “senior secured” issues have a very high ranking in the debt structure and a specific legal claim on company assets in the event of default, and therefore senior secured bonds should have lower default losses. “Subordinated” debt is debt which ranks below all senior issues, and thus has a lower claim on company assets. Senior subordinated bonds and other junior bonds typically have no specific security. They are backed only by the general creditworthiness of the issuer, and thus have a lower legal claim and larger default losses. Most high-yield issues are senior subordinated bonds, but each high-yield issue is unique with respect to its seniority and its legal claims on company assets. These details are spelled out in the bond issue’s legal document called the bond “indenture”. High-yield bond prices have been highly cyclical. The high-yield market has been through several multi-year cycles of pronounced highs and lows. Typically, these cycles begin when unusually large numbers of new high-yield issues are sold in a period when the economy is strengthening, the market is optimistic, and interest rates are relatively low. Often, these new issues are poorer quality bonds that could not be sold in a more cautious market. Usually within two or three years, these weak issues begin to have problems and a significant number actually default, causing default losses to jump. Investors become more fearful and add more selling pressure to the market. Yields eventually climb to very high levels. Finally, when the defaults have peaked and the generous yields have attracted new money to the market, yields begin to drop. Eventually the cycle begins again with the return of optimism and larger numbers of new issues. To earn attractive returns on a high-yield bond portfolio, an investor must understand and take advantage of these pronounced cycles in the market. There are times to be more cautious and times to be more aggressive in the high-yield market. The high-yield bond market has developed over the years as an “institutional” market and market activity is led by large institutional investors. Daily bond trades in the market are denominated in a “round lot” of one million dollars of face value. In addition, compared to issues of investment-grade bonds, individual high-yield bond issues have an extremely wide variation of returns. This variability makes a larger, well-diversified portfolio a necessity for high-yield market participants. The combination of these factors means that the most effective way for an individual investor to participate in the high-yield bond market is through the ownership of shares in a well-diversified high-yield bond mutual fund. Bond mutual funds usually pay monthly or quarterly distributions of income that are typically taxed as ordinary income. Investors have often run into problems caused by an overemphasis on a fund’s current yield. Bond fund distributions will change over time. Do not assume that the payments on a bond fund today will remain the same in the future. As a fund’s portfolio goes through changes over time, its income will also change. Even the SEC yield used in advertisements and fund information is based only on a fund’s yield as calculated for a 30-day period. We urge you to properly evaluate a bond fund investment in terms of its total return performance over a period of years, not just in terms of its recent current yield. Why Invest in High-Yield Bonds? High-yield bonds pay higher interest coupons than investment-grade bonds to compensate investors for a higher risk of default and loss of principal. Because their investment returns are highly dependent on the issuer’s future profitability, high-yield bonds also have some of the performance characteristics of common stocks. Therefore, in simple terms, studies have shown that high-yield bond returns are approximately 50% correlated with returns in the investment-grade bond market and approximately 50% correlated with returns in the stock market. Thus the attributes of returns on high-yield bonds fall in the middle ground between stocks and bonds. This unique combination of performance characteristics is well-suited to the group of investors who seek higher returns than those available in a conservative bond portfolio, but who do not want to take the higher risks of a stock market investment. There are three primary reasons to invest in high-yield bonds: 1) The investment advantages of a high interest coupon. The high interest coupon component of returns makes any fluctuation in bond prices less important in the total return of a portfolio. It also enhances the long-term returns attributable to the sheer power of compound interest, and also shortens the “duration” of a bond. “Duration” is a measure of a bond’s sensitivity to changes in interest rates. All else being equal, a bond with a high interest coupon will have a shorter duration and will have less price variance than a bond with a low interest coupon as interest rates change over time. Thus, the high regular interest coupons mean that high-yield bonds have less volatility than stocks. 2) High-yield bonds have some capital gains potential. Bonds can appreciate in value because: 1) the general level of interest rates falls, 2) a bond’s risk level declines due to a strengthening of the issuer’s financial condition, 3) economic conditions improve, or 4) the bond is upgraded to a better credit rating. 3) High-yield bonds help to diversify portfolio returns. With their relatively low correlation to investment-grade bonds and stocks, high-yield bond returns are somewhat unique and can help diversify the returns from other asset categories. Therefore they can enable a broadly diversified investment portfolio to achieve better long-term returns with lower long-term risk. |
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Date of First Use as Revised in Present Form 1/11/2008
Copyright © 2008 Aegis Financial Corporation. All Rights Reserved. Funds Distributed by Rafferty Capital Markets, LLC. www.aegisfunds.com Please consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. View a prospectus containing this and call 800-528-3780. Please read the prospectus carefully before investing. View our Privacy Policy. |
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