Did you know that some high yield bonds give different coupon payments?
The High Yield Market has different types of bonds which is useful when achieving a diversified portfolio.
So far, our blog series has covered the following:
- What is a corporate bond?
- What are credit ratings?
- What is creditworthiness?
- Bond security
- Bond seniority
- Different types of debt
- What are the differences between bonds and equities?
- Why do bonds move in price?
- What is yield and the Yield Curve?
- Opportunity cost
Now, we will begin to examine the different types of bonds, markets, and yields that you will come across when investing in the bond market.
Different types of bonds
Having a diversified portfolio is key when attempting to achieve success with your investments.
Investing in different types of bonds is a good way to accomplish this.
Euribor and Libor
Euribor is the Euro Interbank Offered Rate – this is the interest rate that a bank will charge another bank to borrow funds.
Libor is the London Interbank Offered Rate – the Sterling equivalent.
Floating Rate Notes
Floaters or FRNs are different from regular high yield bonds because their coupon varies with the current market rate.
For example, a bond might have a coupon of 3-month Euribor + 200 basis points.
Say what now?
Let’s go through this step-by-step.
A bond has regular coupon payments until it matures – we know this already.
Now, 1 basis point is 1/100th of a percent.
This means that 200 basis points is equal to 200/100th of a percent – so 2%.
As mentioned earlier, in this example, the coupon is set every 3-months.
Therefore, a bond paying a coupon of 3-month Euribor + 200 basis points will have a coupon of Euribor +2%, which is set every three months.
And that’s why we call it a Floating Rate.
Floating Rate Notes have low sensitivity to interest rates because the coupon rate is always changing.
Effectively, the interest component is never far off the market rate.
This means that floaters tend to trade much closer to par than a fixed-rate bond, for example.
FRNs sometimes have what is called a Non-Call One structure.
This means they are callable after one year which keeps prices closer to par.
Pros and Cons
FRNs are good to own compared to fixed-rate notes due to their potentially higher rate of return in a rising rate environment.
This can also be a disadvantage should the benchmark rate start to fall.
You can also feel confident with repayments if you are lending money to a well-established and reputable company.
Again, a downside is that there is a potential for non-payment if you are dealing specifically with a private institution.
There is also a tendency for Floaters to have a lower rate of return, however, due to the short-term nature of the issuing.
Conversely, short-term maturity rates also return your principal relatively quickly.
Another drawback is that the FRN market is relatively small which means liquidity can be an issue.
Not only this, but FRNs tend not to be included in high yield bond indices – they have their own.
These bonds are generally issued by investment grade companies and have characteristics of both debt and equity.
As a result, rating agencies assign “Equity Credit” to hybrids, treating a portion of the debt as equity.
Usually between 50% and 70%.
Do you remember learning about bond seniority?
You can have senior debt and you can have junior debt.
Well, corporate hybrids are effectively junior to all debt in a company’s capital structure.
Hybrids have a “perpetual” or very long-dated final maturity, with multiple call dates.
There are multiple call dates due to the assumption that the bonds will be replaced with another corporate hybrid.
No security? So, it’s basically equity?
Well, not entirely – but it’s understandable to come to that conclusion.
Corporate hybrids are equity-like in that they do not have a maturity date.
Like equity, they have no security and take the first losses in any financial distress.
As a result, they are normally rated 2-3 notches below the unsecured debt of the issuer.
Just another word for rating.
In other words, corporate hybrids are rated 2-3 ratings below the unsecured debt of the issuer.
Pros and Cons
To begin with, the issuer can benefit from accounting the hybrids as debt on its financial statements.
Rating agencies will also not penalise the company to the same degree they would if they issue unsecured debt.
This makes corporate hybrids a very attractive investment opportunity.
They are issued by investment grade companies and can offer enticing yields.
Hybrid’s major fallback is that they generally have a high sensitivity to market moves.
At times, there has been uncertainty about whether existing hybrids will qualify for equity treatment.
This is because rating agencies have their own treatment and requirements for corporate hybrids.
In recent times, this has been less of a case, but regulatory risk and rating agency risk are things to be mindful of.
Firstly, what a name!
Contingent Convertible Bonds – or CoCos – is a bond where the holder has the right to convert the bond into equity at a predefined equity price or a predefined ratio.
On a specified “trigger” event the debt of a CoCo is converted into equity.
After the financial crisis in 2009, regulation sought to de-risk banks.
The use of CoCos essentially provides an equity injection to the business in times of stress and there are two key components to a CoCo.
This is an event that causes the debt to be converted to equity – usually when a company needs a cash injection.
For example, the level of regulatory capital required to be held by the bank falling below a certain level.
It could be linked to the share price, or even to management and regulatory decisions.
It could also be a combination of these.
Like a convertible bond, this sets out how many shares a bond is converted into.
When investing in CoCos it is important to understand the trigger and conversion rate as these can vary for the same issuer.
Regulatory risk is high for CoCos given banks are regulated entities.
Hybrid capital also carries more risk than secured or guaranteed debt.
Its function is to absorb losses and provide a buffer in times of stress.
In exchange, investors receive a higher rate of return.
Our next blog…
We will begin to understand the roots of the European and Sterling High Yield Markets.
You will learn about Rising Stars and Falling Angels, as well as the different market types you can invest in.
As usual, all of this content can be found on our free Bond Academy, a CPD accredited course that offers 5 hours of CPD activity.
If you have any ideas on topics you’d like for us to talk about, please email me: email@example.com.