High-Yield Bond

The yield on a speculative-grade bond can be decomposed into the benchmark government yield plus a credit spread. That spread must cover three things: expected credit loss, compensation for the uncertainty around that loss, and a liquidity premium, since below-investment-grade issues trade less frequently and in smaller size than sovereigns or large investment-grade benchmarks.

Expected credit loss over a period is the probability of default multiplied by loss given default, where loss given default equals one minus the expected recovery rate. A bond with a five percent annual default probability and a forty percent recovery implies roughly three percent of expected annual loss, so a spread of three hundred basis points would leave the investor uncompensated for risk and illiquidity. This is why realised returns on high-yield portfolios are systematically lower than quoted yields to maturity: the quoted yield assumes every coupon and the full principal arrive.

Because default is a live possibility, documentation matters far more than in investment grade. Incurrence covenants restrict actions such as taking on additional debt, paying dividends or selling assets; maintenance covenants, more typical of leveraged loans, require ongoing compliance with leverage or coverage ratios. Recovery depends on where the instrument sits: secured bonds rank ahead of senior unsecured, which rank ahead of subordinated debt, and debt issued by a holding company is structurally subordinated to obligations of the operating subsidiaries that actually own the cash-generating assets.

Call features cut the other way. Speculative-grade issuers want the option to refinance if their credit improves, so bonds usually carry a non-call period followed by a declining call schedule. That option caps upside: as spreads tighten, price appreciation compresses toward the call price, producing negative convexity.

The high-yield universe has two entry routes. Original-issue paper is sold by companies that were never investment grade, including leveraged buyouts financed with a mix of bank loans and subordinated bonds. Fallen angels are former investment-grade issuers downgraded across the threshold, which forces selling by mandate-constrained portfolios and index funds and can create temporary price dislocations independent of fundamentals.

Aggregate spreads behave cyclically and with high beta to equities. They compress when growth and refinancing conditions are benign, then widen sharply and non-linearly when the default cycle turns, because rating migration, falling recoveries and evaporating liquidity reinforce one another. Sector composition matters too: energy, telecommunications and retail have historically dominated distressed cohorts, so index-level spreads often reflect concentrated industry stress rather than broad deterioration.

A candidate should be able to move between rating category, spread and expected loss in either direction: estimate a breakeven default rate from a quoted spread and an assumed recovery, or judge whether a spread adequately compensates for a given probability of default. Spread duration is the second core tool: the approximate percentage price change equals the negative of spread duration multiplied by the change in spread, with a convexity adjustment for large moves.

Credit assessment at this level rests on leverage and coverage measures such as debt to EBITDA, EBITDA or EBIT to interest expense, and free cash flow after capital expenditure, read alongside the collateral, covenant package and seniority of the specific instrument. Candidates should also recognise that high-yield returns correlate more closely with equity than with government bonds, which limits their diversification value precisely when it is most wanted.