Posted  on October 8th, 2015 by Ben Connard

The current low interest rate environment has resulted in a search for yield. This search has led investors to high yield, or junk, bonds. As a result of the increasing demand, the spread between investment grade and junk bonds narrowed substantially until the past few months when it started to widen again. Companies took advantage of historically narrow spread by issuing more debt on more favorable terms.

Junk bonds are rated BB and below. Bonds usually receive low ratings because they are issued by companies with weak balance sheets. However, some bonds are poorly rated even though they are issued by companies with strong balance sheets since the specific bonds are subordinated within the capital structure. Junior debt has a lower priority claim against assets if a company goes into bankruptcy. Preferred stock is a kind of junior subordinated debt/equity hybrid that provides a high yield, and often, a perpetual duration.

Banks are big issuers of preferred stock because the proceeds from their issuance may count towards Tier 1 equity targets. Some banks have also issued subordinated debt that is a hybrid of fixed-income and preferred stock. These securities pay a fixed coupon for a number of years, then switch to a floating rate. This debt is often callable once it’s floating.

We have limited exposure to preferred stocks and do not invest in these hybrid bonds since they do not provide a hedge against the volatility associated with common stocks. During the financial crisis, some bank preferred stocks traded below $10 vs. a par value of $25.

A callable perpetual note also has limited upside. If the issuer is paying an above market rate on the debt, it will be called away, and the investor will lose the high yield. If the bond is not called, it generally means the issuer is paying a below market rate – in other words, the investor is not being properly compensated for his or her risk.

The worst outcome is the issuer goes bankrupt and the investors are unable to recover the value of the bond due to their priority within the capital structure. This outcome can happen with any debt instrument, but it is more likely with junk bonds and junior debt.

The most likely scenario with a junk bond is generally positive—the investor receives above average interest and is paid in full at maturity or the call date. But, given the volatility and limited upside, we do not find these securities appealing investments.