Introduction to Corporate Finance

14: Long-Term Debt and Leasing

Share Purchase Warrants

Like term loans, bonds occasionally have warrants attached as sweeteners to make them more attractive

to prospective investors. As we noted previously, a share purchase warrant gives its holder the right to

purchase a certain number of shares of ordinary shares at a specified price during a certain period of time.

14 -3e HIGH-YIELD BONDS

The risk of publicly traded bond issues is assessed by independent agencies such as Moody’s and Standard &

Poor’s (S&P). Both agencies have 10 major bond ratings derived by using financial ratio and cash flow

analyses. Bonds rated Baa or higher by Moody’s (BBB– or higher by S&P) are known as investment-grade

bonds. Bonds rated below investment-grade are known as junk bonds, high-yield bonds or speculative bonds.

As the name suggests, junk bonds carry a much higher default risk than do investment-grade bonds, but

they also offer higher yields. Until the late 1970s, such issues were quite rare. Historically, most of these

speculative bonds trading in the market were fallen angels, bonds that received investment-grade ratings

when they were first issued but later fell to junk status.

Junk bond default rates typically peak during recessions. When junk bond default rates rose sharply

during the 1990–91 recession, many commentators wrote off high-yield debt as a viable financing tool.

As Figure 14.1 shows, the percentage of bonds issued in the US with ratings B or below (i.e. junk bond

status) did not disappear during the global financial crisis, when they were most under stress; but their

importance in the market has fluctuated. Following times of sharp market decline (2000 and 2008) the

junk bond market fell as a fraction of all bonds issued; but the issuance rates recovered in both instances.

Junk bond investors recognise that they are assuming much of the issuing company’s operating (business)

risk when they purchase high-yield debt, but they are willing to do so in return for promised yields that

approach the returns earned by shareholders. Of course, a higher promised yield may or may not result in

a higher realised return, because the higher yield reflects a higher likelihood that the borrower will default

(in whole or in part) on the bond some time during its life. In other words, owing to the risk of default and

investment-grade bonds

Bonds rated Baa or higher

by Moody’s (BBB– or higher

by S&P)

junk bonds

Bonds rated below investment

grade (also known as high-

yield bonds or speculative

bonds)

high-yield bonds

Bonds rated below investment

grade (also known as junk

bonds or speculative bonds)

speculative bonds

Bonds rated below investment

grade (also known as high-

yield bonds or junk bonds)

fallen angels

Bonds that received

investment-grade ratings

when first issued but later fell

to junk status

FIGURE 14.1 PERCENTAGE OF NEW HIGH-YIELD ISSUANCE RATED B OR BELOW, 1993–3Q 2013,

BASED ON AMOUNT OF ISSUANCE

70

60

50

40

30

20

10

0

18.16

23.35

19.4021.48

27.27

40.75

30.41

32.97

13.7314.02

29.55

39.06

33 33.57

51.25

14.16

21.38

26.73

31.5629.62

27.41

19931994199519961997199819992000200120022003200420052006200720082009201020112012

2013 (3Q)

%

Source: S&P Capital IQ LCD. Used with permission. Altman, Edward I., and Brenda J. Kuehne, ‘Defaults and Returns in the High-Yield Bond Market: Third-Quarter 2013 Review’,

Journal of Financial Management Markets and Institutions, Vol.1, Number 2, 269–296.