Understanding Long-Term Corporate Debt | CFA Level I

Today, we’re diving into the intricate world of long-term corporate debt, focusing specifically on the nuances between investment-grade and high-yield corporate issuers.

Why Companies Issue Long-Term Debt

In previous discussions, we’ve touched on why companies might opt for long-term debt: funding capital investments and preferring the stability it offers over short-term financing. Long-term debt is appealing for its predictability and lower rollover risk. Today, we’re expanding on these concepts to explore how investment-grade and high-yield issuers navigate this landscape.

Common Ground: Similarities Between Investment-Grade and High-Yield Issuers

At first glance, investment-grade and high-yield issuers might seem worlds apart. Yet, they share common challenges and strategies in issuing long-term debt. Both must carefully weigh the maturity length of their debt, balancing the risk of higher interest costs against the benefits of lower rollover risk. This decision involves considering benchmark risk-free rates and credit spreads, which naturally are higher for high-yield issuers.

Interestingly, some high-yield issuers might opt for shorter-term debt to mitigate interest costs. Let’s consider a high-yield issuer with a 10-year project facing a 12% interest cost for 10-year debt. By opting for 5-year debt at 9%, they bet on rolling over the debt at a favorable rate in the future, despite the rollover and interest rate risks.

From an investor’s perspective, the choice between bonds of different maturities presents its own set of risks, including price risk and reinvestment risk. For instance, an investor with a 6-year horizon might be tempted by the higher yield of a 10-year bond, planning to sell early despite the uncertainties of bond prices and future interest rates.

Drawing the Line: Key Differences

The divide between investment-grade and high-yield issuers becomes stark when examining their credit ratings, specifically between BBB and BB. Here’s where the paths diverge significantly:

• Investor Confidence: Investment-grade issuers, with their stronger debt repayment abilities, enjoy high investor confidence. This allows them to issue long-term debt with fewer restrictions. High-yield issuers face more scrutiny and covenants to protect investors due to their higher default risk.
• Debt Structure: Investment-grade bonds are typically standardized, allowing issuers to strategize around refinancing risks with varying maturities. High-yield bonds, resembling equity in their uncertainty, come with stringent conditions on further debt issuance.
• Flexibility and Constraints: Investment-grade issuers benefit from flexibility in choosing debt maturities and face fewer covenants, whereas high-yield issuers are limited by shorter maturities and restrictive covenants, impacting their ability to manage interest costs.
• Callable Features: High-yield bonds often include callable features, offering issuers the chance to refinance at lower rates if their creditworthiness improves, contrasting with the typically non-callable nature of investment-grade debt.

An intriguing aspect of the high-yield market is the phenomenon of “fallen angels,” issuers downgraded from investment-grade to high-yield. These entities present a unique mix of characteristics, combining investment-grade debt features with the challenges of a high-yield rating.

Conclusion: Navigating the Corporate Debt Landscape

Both investment-grade and high-yield issuers must navigate the complex terrain of long-term debt issuance, each with its strategies and challenges. For issuers, understanding these distinctions is key to optimizing debt structures. For investors, it’s crucial in balancing portfolio risk and return.