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HIGH YEILD BONDS

HIGH YEILD BONDS A bond is debt to whoever sells the bond to an inventor. If you buy an IBM bond, you are loaning money ($1000) to IBM instead of a bank loaning money to them. Just like a bank, you are going to charge IBM interest on your money, as well as a return of principle when the loan is due (ten years later). The company does not go to the bank to borrow the money, because the bank will rate the company as a high risk company. Hence, banks are really tight with their money. High yields bond investment relies on an credit analysis in that it concentrates on issuer fundamentals, and a “bottom-up” process. It focuses more on “downside risk default and the unique characteristics of the issuer. In a portfolio of high yield bonds, they are diversified by industry group and issue type. Due to the high minimum size of bond trades, most individual investors are best advised to invest through high yield mutual funds. High yield bonds or “junk” bonds get their name form their characteristics. As credit ratings were developed, the credit agencies created a grading system to reflect the relative credit quality of bond issuers. The highest quality bonds are “AAA and the credit scale descends to “C”, and finally to the “D” of default category. Bonds are considered to have and acceptable risk of default or investment grade and encompass “BBB” bonds and higher. Bonds “BB” and lower are called speculative grade and have a higher risk of default. Most investors were restricted to investment grade bonds, speculative bonds developed negative connotations and were not widely held investment portfolios. Mainstream investors and investment dealers did not deal in these bonds. They result in junk since few people would accept the risk of owning them. In the 1980s, most junk bonds resulted from a decline in credit quality of former investment grade issuers. This was a result of a major chance in business conditions, or assumption of too much financial risk by the issuer. Along with the many different characteristics of bonds such as, the way the pay their interest, the market they are issued in, the currency they are payable in, protective features and their legal status. Bond issuers may be governments, corporations, special purpose trusts or even non-profit organizations. Usually it is the type of issuer or the particular nature of a bond that sets it apart in its own category. A supranational agency is like a World Bank, that leaves assessments or fees against its member governments. The most important factor is the support and taxation power of the underlying national governments that allow these organizations to make payments on their debts. The “central or national governments also have the power to print money to pay their debts, as they control the money supply and currency of their countries. This is one reason why investors consider national governments (bonds) of the most industrial countries to be almost “risk free” from a default point. Many government related institutions issue bonds, some supported by the revenues of a specific institution and some guaranteed by a government sponsor. For example, in Canada they have a bank that issue bonds that are guaranteed by the Federal government. The business prospects of companies are dependent on the economy and the competitive situation of industries. Issuers are grouped by industry, for example real estate, resource and retail bonds. Industries with stable revenues and earnings are called “non-cyclical”, where as those who revenues and earnings rise and fall with the economy and commodity prices are called “cyclical”. Issuers are also grouped by their credit ratings. Companies that have financial risk , because of high levels of debt and variable revenues and earnings are called “below investment grade” or “ junk bonds” because of their speculative nature. Higher quality bonds are considered investment grade. An inflation-linked bond is a bond that provides protection against inflation. Most inflation-linked bonds, the Canadian “Real Return Bond”, the British “Inflation-linked Gilt”, and the new US Treasury “inflation-protected security” are principal indexed. This means their principle is increased by the change in inflation over a period of time. I most countries, the Consumer Price Index is used as an inflation proxy. As the principal amount increases with inflation, the interest rate is applied to this increased amount. This causes the interest payment to increase over a period of time. At maturity, the principal is repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as long as the investor’s inflation rate equals the Consumer Price Index. A convertible bond is a bond that gives the holder the right to convert or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period. As bonds, they have some characteristics of fixed income securities. Their conversion feature also gives them features of equity securities. The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares a specified price or conversion ratio. For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of IBM Corporation in its common shares at $25 per share. This conversion ratio would be four to one. Bond issuers sell convertible bonds to provide a higher current yield to investors and equity capital upon conversion. Investors could sell convertible bonds to provide a higher current yield to investors and equity capital upon conversion. Investors buy convertible bonds to gain a higher current and less downside, since convertible bonds trade its bond value in the case of the common share price. Investors traditionally use the break-even analysis to compare the coupon payment of the convertible to the divided yield of the common shares. Modern techniques of option analysis examine the convertible as a bond with an equity option attached and value it in this manner. The value of a bond depends on the size of its coupon payments, the length of time remaining until the bond matures and the current level of interest rates.. The value of the bond is the present value of its cash flows (coupons and principal). Discounted at a suitable interest rate. One convention used to simplify the calculation procedure is to assume a single rate for all cash flows. This is known as yield to maturity. Yield to maturity is a yield that equates the present value of all the cash flows from a bond to the price of a bond. When the price is given the YTM can be calculated. A rise I the YTM will cause the price calculated to decrease, while a fall in the YTM will cause the price to rise. This concludes that that all of the coupons can be reinvested at the same rate. The actual return generated by a bond held until maturity on the future reinvestment rates which the coupon payments are invests. Duration is a measure of the average (cash) term to maturity of a bond. The value of a bond will vary depending on the amount of the cash flows(coupon), timing of the cash flows (term to maturity), and the interest rate used for discounting. Duration helps to summarize these variables in a single number. There are two types of duration, macaulay duration and modified duration. The high-yield bond market is an exciting, growing area of investment. However, before investing in high returns, take a closer look at the company that is issuing the bond. High-yield bonds are more vulnerable to default than investment-grade bonds. Taking the time to research companies can reveal hidden gems and exposed concealed weaknesses. A competitive company with a solid management and a sound business and financial strategy will likely prosper-even through its credit rating may not be high. A struggling company with weak management and a reluctance to adapt to changing business situations is obviously a much higher risk. For example, at the company Trimark they evaluate each of their companies for equity funds and bonds. They also use the bottom-up long term investing approach to search for bonds that are undervalued by the market and then they will purchase and hold the bonds until they reach their value. Their are several steps that can be taken by anyone who wishes to buy high-yield bonds: One of the most critical steps in the process is visiting the company and meeting the management team. Asking questions and listening to their answers is important when deciding whether or not to invest. All of the records should be examined, this will conclude how the company reaches their projected goal annually. It is very easy for a company to put together a flashy annual report. Conducting an in-depth analysis of the company, is the second most important step in choosing a company to invest within. Looking at a companies profitability and evaluating their assets is the overall objective in the company analysis. To test these two objectives, one can change the key variables to see, for example, what would happen to key credit if the gas prices rose to an all time high. Another important question that a company should ask, is the company a low-cost operator? If the company produces a product at al lower cost relative to its peers in the industry, it will probably survive and prosper. Analyzing a company in their specific organizational functions is most important, because no company operates in a vacuum. No matter how solid the management and balance sheet of a company are, its profitability will be affected by the strength of their rivals. So the company should examine the companies and determine what kind of threat the possess. Companies should also pay attention to the changes that occur in each particular industry. For example, the innovations in technology. Because when making long term investments, the company should make sure that they can financially adapt to the changing situations. The last step that should be followed is determining the relative value of the bond, in contrast to the agency determined rating. Comparing the credit statistics of the company to those of the industry peers, will result in a true sense of the ratings. Analyze on the indenture (terms and conditions) of the bond: its covenants, corporate structure, security and redemption features. Finally, the company should examine the pricing of the bond in relation to alternatives in the same industry, and to bonds in other industries with comparable ratings and credit statistics. Bibliography:

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