“Junk bonds” are often still considered an alternative asset class and remain tremendously confusing to much of the investing public. They are considered by many to be very risky and illiquid. The truth is that the high yield market is a relatively straightforward, well developed and liquid market.
It is important to gain an understanding of the fixed income marketplace and the investment options within it. The first thing to note is the sheer size, which is massive (more than $40 trillion).1 Somewhat surprisingly, mortgages represent the second largest single subcategory of the bond market; this helps to explain why problems in the mortgage market nearly took down the entire financial system in 2008. The largest subcategory is U.S. Treasury debt.
Yet, a sizable 25% of the fixed income universe is represented by “corporate credit” through leveraged loans, high yield bonds and investment grade corporate bonds. What comes as a surprise to many investors is that the non-investment grade sector of loans and bonds has grown to become a major asset class, now over $2.0 trillion.
We have seen record issuance in the leveraged loan and high yield market over the past couple years, making it likely this segment of the market will make up a larger percentage of the fixed income pie in the future.
By looking at the chart above it is obvious that corporate credit plays a major role in financial markets; yet, for some reason, bonds have always been considered too complex for individual investors and often remain misunderstood. While it is true that large players, such as insurance companies, pension funds and banks, dominate the landscape, bonds at their core are simple. A bond is a loan.
A company can issue debt (bonds) or equity (stock). The debt/bonds rank ahead of equities in a company’s capital structure, so are considered less risky. This ranking means that bondholders have a priority claim on the company’s cash flows and get paid first. Corporate bonds have a maturity and an interest rate, creating a contracted stream of income for bondholders.
They typically pay this interest twice per year but trade with accrued interest, meaning that a buyer can buy the bond anytime before the paydate but would have to pay the seller the accrued interest up to that point. The maturity is the date at which the issuer is obligated to pay the bondholder back the “par value” of the bonds. Companies generally have the ability to refinance at some point prior to that maturity, but must typically pay the bondholder a call, or tender premium (pre-payment penalty), to do so. This finite exit strategy, either via maturity or refinancing, is one of the great features of bonds versus equities.