On P247 of Level 2, Vol 1, in the top section, it says, “High yield bond returns hehave more similary to equity returns than to debt returns”. I know that high yield bonds are somewhat between equity and fixed income securites, but i need some rationalization. could someone help ? thanks.
Accounts for default risk, all they are saying is that there is a somewhat corr btw the returns of equities and high yield bonds, does that help?
also because maybe those high yield bonds ARE NOT secured or have junior claims to higher level debt, and if in the event of liquidation the amount returned to holders is one tier above equity holders…so the likelihood of being repaid is as low as a high beta/highly speculative equtiy security and due to that those bond holders require returns in line with equity securities, hence the correlation.
High yield bond also is quite often issued as convertible bond where the holder has an option to convert the bond to equity (some time in the future). Therefore, if share price has increased above the strike price, the bond’s pay off is like shares since the bond will virtually be converted.
would they also consider bonds with call options or sinking fund provisions having the same inherit risk?
Hmm Difficult to say. If a bond has an added call option and sinking fund provision, I would say its behavior/return is more bond-like compared to same bond without. - Call option: Its price volatility thus return will be less (as function of interest rate change) thus more bond-like. - Sinking fund: the investor will have more certain chance to get paid --> less volatility. BTW, you may want to know the following definition IFRS uses to categorize an instrument as equity or liabilities (IAS 32) "not classify the financial instrument as equity if the issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation* The call option and sinking fund are consistent of liabilities categorization according to the above mentioned definition. Just my two cents.
thanks elcfa, seems like you have the L2 material down!