Not all high-yield corporate bonds are created equal. There are, in fact, several different features of the bond that differentiate high-yield corporate bonds from one another. However, as their name suggests, high-yield corporate bonds do share some things in common. Specifically, aspects like coupon and maturity that help determine a bond's value and security. The significant features, which differentiate the types of high yield corporate bonds are: “whether, when and at what price a bond is callable by the issuer, conditions on a put by the bondholder, covenants related to financial performance and disclosure, and even equity warrants,” (Standard & Poor’s Financial Services LLC, 2015).
Types and Structures of High Yield Corporate Bonds
As the high-yield corporate bond market has evolved, the types and structures of high-yield corporate bonds have grown as well, becoming more specialized and complex. Now, there are several significant types of high-yield corporate bonds investors may choose from in the current market:
- Straight Cash Bonds
- Split-Coupon Bonds
- Pay-in-Kind Bonds
- Zero-Coupon Bonds
- Floating-Rate or Increasing-Rate Notes
- Deferred-Interest Bonds
- Extendable Reset Notes
- Convertible and Multi-Tranche Bonds
Straight Cash Bonds – This type of bond is considered the typical, or “vanilla” high-yield corporate bond. Straight cash bonds usually offer a fixed coupon interest rate that’s typically in cash and made semiannually via a call or maturity date. The interest rate (coupon) of such bonds tends to compound twice annually. On average, most high-yield bond issuers have remained somewhere in the approximately 6-8% area, but that doesn’t mean it’s unusual to see this reach double digits.
Split-Coupon Issues and Bonds – Such bonds are those that pay out at a lower rate earlier in life before reaching a higher interest rate (the split-coupon issue or step-up note) later on as the bond ages.
Pay-in-Kind Bonds – Often abbreviated as PIKs, these bonds are designed to give the issuer the options of interest payouts in either (1) cash or (2) additional securities, or (3) to pay “in-kind” with even more bonds. Such a bond is designed to allow the issuer a bit more breathing room when it is needed over straight-cash bonds. However, paying “in-kind” also means that a company can accumulate more debt the more often they do this, which can be a paradoxical and risky way to secure against debt. This is similar to how zero-coupons work and why both zero-coupon and PIKs are considered among the most highly-speculative of high yield corporate bond structures. In the past ten years, a sub-sect of PIKs have also been introduced, the Floating -Rate or Increasing-Rate Note (FRNs or IRNs). However, these are far less popular than PIKs.
Zero-Coupon Bonds (Zeros) – Such bonds are sold at a steeply discounted price off the face value of the bond’s issuance. In exchange for this, there is no interest paid to the bondholder until the bond has completely matured. Often called a zero or a zip, these allow companies to issue bonds even if they know they’ll be in no position to pay them back for years to come. For the investor, these deals are attractive because of their steeply discounted price. Additionally, the value of the bond for the bondholder comes from capital appreciation instead of interest payments. These types of bonds became popular in the late 90s as the internet, and wireless build-out projects and start-ups became increasingly popular.
Floating-Rate or Increasing-Rate Notes – Both FRNs and IRNs fluctuate on interest payments in relation to the changed in a benchmarked interest rate or a specific schedule developed for such payments. Though uncommon, when interest rates are rising, FRNs can help make a bond more attractive to an investor as they typically pay out four times a year and at a spread set by the LIBOR rate.
Deferred-Interest Bonds – This type of bond is simply one where the issuer does not have to pay the bondholder any interested until the future date set on the bond.
Extendable Reset Notes – With this bond, the issuer has a bit more flexibility because they have the option to reset the rate of the coupon and extend the maturity date of the bond under certain circumstances or after a defined length of time. For the bondholder, ERNs give them the option to sell or “put” the bond back to its original issuer as well.
Convertible and Multi-Tranche Bonds – Convertible bonds are those that can be converted into another security under certain terms. Typically, this alternate security is simply the company’s standard or common stock. Multi-Tranche Bonds give bondholders multiple tiers of investment opportunities within the same issue. These tiers tend to differ in their (1) credit quality and (2) targeted maturities.
Other Significant Features of High Yield Corporate Bonds
It’s not uncommon for companies issuing high-yield corporate bonds to package in features to make their bonds more attractive to investors. Typically, these “convertibility” features can help companies negotiate better terms or lower interest rates so they can be useful for both bondholders and issuers depending on the specifics. For investors, such convertibility features can help them collect a more secure and steady stream of additional income and perhaps provide an opportunity for future stock price appreciation options. However, investors should note that bonds offering such features may also carry the risk of being callable and should also check the issuer’s credit rating to see if issues exist that may negate the advantages such features provide.
These are many of the common convertible features that issuers often add to high yield corporate bonds in order to make them more attractive:
Equity Warrants – Many of the highest speculative bonds will carry equity warrants in order to make them more attractive to investors. A warrant is an option to buy equity in the company at a later date upon the purchase of the bond. Most issues of this type will carry warrants that allow ownership of the company of up to around 5%. However, some speculative startups have been known to offer as much as 15-20%.
Bullet Structure or Notes – This is the commonly used term to refer to full-term call protection or non-call-life. This makes a bond look more attractive because it has less risk of being refinanced. Conversely, this also means bullet note bonds pay out relatively lower yields.
Make-Whole Call Premiums – This is the standard in investment-grade certified issuers and still fairly prevalent in the high-yield market at well. The idea here is that an issuer can forgo the whole entirety of the call structure in favor of offering bondholders a premium market value for the early retirement of their bonds. In essence, this is a call, but for a far higher price than other offerings. Most use a lump-sum payment setup that includes a price for the earliest call period and the net present value of the total of coupons that would have been paid to the first call date. This is determined with a pricing formula whose yield is equal to a “reference” security plus a “make-whole” premium.
Put Provisions – A put provision is the exact opposite of a call. These provide the holder a way to speed up the repayment at certain, predefined amounts under certain circumstances. The most common example of a put would be the change-of-control put, and this is usually set at 101%. In this example, if there is a significant change in the ownership and board of directors for a company, wherein a third party has purchased it, the bond will have to be retired by the issuer.
The Bottom Line
There are several significant types of high-yield bonds such as straight cash bonds,pay-in-kind bonds, and zero-coupon bonds. High-yield bonds have become increasingly more specialized and complex over the years. When considering purchasing a bond, take the time to evaluate its features and risks.