Investment Grade vs High Yield
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Not all corporate bonds are created equal. The dividing line in the market runs between investment grade and sub-investment grade bonds, defined by credit ratings:
- Investment grade: rated Baa3/BBB- or above by Moody's/S&P respectively. These are companies considered to have sufficient financial strength that default is unlikely under normal conditions. Examples include large, established companies such as Apple, Volkswagen, or BP.
- High yield (also called sub-investment grade or, pejoratively, "junk"): rated Ba1/BB+ or below. Higher default risk, compensated by higher yields.
The credit spread is the additional yield a corporate bond pays above the equivalent-maturity government bond yield. It is the market's price for taking on credit risk. A 10-year corporate bond yielding 6% when the 10-year government bond yields 4% has a spread of 200 basis points (2%). Spreads widen in periods of economic stress — when investors demand more compensation for default risk — and narrow in calmer periods.
The Origins of the High-Yield Market
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The modern high-yield bond market was largely created by Michael Milken at Drexel Burnham Lambert during the 1980s. Before Milken, the bond market was almost exclusively investment grade: companies without pristine credit ratings simply could not access the public bond market. Milken's insight was that a diversified portfolio of sub-investment grade bonds could offer attractive risk-adjusted returns, because default losses were more than compensated by the yield premium.
Drexel became the dominant force in financing leveraged buyouts and takeovers throughout the 1980s using high-yield bonds as the funding mechanism. The market has since grown to several trillion dollars globally and provides a vital source of capital for mid-sized companies that do not qualify for investment-grade status.
Covenants: Protecting Bondholders
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Covenants are contractual conditions embedded in a bond's indenture (legal agreement) that restrict the borrower's behaviour or require certain standards to be maintained. They exist to protect bondholders from actions that would increase credit risk after the bonds are issued.
Affirmative covenants require the issuer to do something — maintain insurance, provide regular financial statements. Negative covenants prohibit actions — taking on additional debt above a certain level, selling key assets, paying excessive dividends to shareholders. In periods of strong investor demand for yield, issuers gain leverage and covenants are frequently stripped out or weakened — so-called "covenant-lite" bonds. This reduces bondholder protection and can increase losses in a default.
Default Rates and Recovery
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Edward Altman at NYU Stern and his collaborators, including Vellore Kishore, produced foundational research on high-yield default rates and recovery rates — the percentage of face value bondholders recover after a default. Historical data shows that unsecured high-yield bonds have recovered approximately 40–45 cents on the dollar on average after default, though recoveries are highly variable and covenant-lite structures tend to produce lower recoveries.
Default rates are cyclical. In benign economic conditions, annual default rates for high-yield bonds typically run at 1–3%. In recessions, they spike sharply: during the 2008–2009 financial crisis, the global high-yield default rate reached approximately 13–14%. Portfolio construction in high yield requires taking this cyclicality into account.