High-Yield Credit Portfolio Strategies for CFA Level III

High-yield (HY) issuers are rated below investment grade. Their spreads are wide because default is a real possibility. Returns behave more like equity than like government bonds. Spread changes, defaults and recoveries matter more than moves in the risk-free curve. Duration matters less, and credit analysis matters more.

Covenants are the contract terms that protect lenders. Affirmative covenants say what the issuer must do, such as provide financial statements. Negative covenants limit what it may do, such as extra debt, dividends, asset sales or liens on collateral. Incurrence covenants are tested only when the issuer takes an action. Maintenance covenants are tested regularly, for example a maximum leverage ratio. Loans usually have maintenance covenants. Bonds usually have incurrence covenants. Bonds with few covenants are often called covenant-lite. Issuers can also have call and change-of-control provisions, which matter for price and for event risk.

Recovery analysis asks what each claim receives if the issuer defaults. Absolute priority says senior secured claims are paid before senior unsecured, then subordinated, then equity. In practice, deviations occur in bankruptcy negotiations. A common approach is to estimate enterprise value at default (a distressed EBITDA times a multiple, or liquidation value of assets), subtract senior claims and costs, and see what is left for each class. A secured loan with collateral coverage often recovers much more than a subordinated bond in the same company. Expected loss is approximately probability of default × loss given default, where loss given default = 1 − recovery rate.

Leveraged loans versus HY bonds. Leveraged loans are typically floating rate (a reference rate plus a spread), senior and secured, and often prepayable. They usually have maintenance covenants and shorter tenors. HY bonds are typically fixed rate, often unsecured or subordinated, with longer maturity and call protection. Loans have lower interest rate duration and usually higher recovery. Loan trading can be slower to settle, and the investor base is narrower. Bonds usually have more price volatility and more liquidity, though HY liquidity can vanish in stress.

Trading and event risk. HY is less liquid than investment grade, with wider bid-ask spreads. Dealers hold less inventory, so selling in stress can be costly. Portfolio managers hold liquidity buffers, diversify across issuers, and limit position size. Event risk includes leveraged buyouts, mergers, large dividends, and downgrades. Distressed debt investing buys claims at deep discounts and aims to profit from restructuring. It requires legal analysis, a view on the likely recovery and on where the claim sits in the capital structure, and a long horizon. Always tie the strategy to the client's return objective, risk tolerance and liquidity needs.

Use this order for any high-yield question, from calculation to recommendation.