High-Yield Lending: It’s Good Until It’s Not

Abstract

Despite the recent popularity of high-yield lending, surprisingly little has been written exploring the highly bifurcated nature of these investments. In this article, the author focuses on pricing these instruments, exploring the potential risks involved and illuminating some of their complexities and nuances (e.g., tranches of different sizes and different positions in the capital stack; mezz debt, which is really equity; covenant-light versus covenant-heavy loan documents; and whether the high-yield has sufficient liquidity to protect its position). In so doing, the author uses an equilibrium approach in which the cost of indebtedness (1) is tied to the expected return on the asset (which, in turn, is a function of the asset’s risk) and (2) increases geometrically with increases in the project’s loan-to-value ratio. The lender has effectively sold a put option to the non-recourse borrower. As the author notes, it is a daunting challenge to determine whether these intricacies have been fairly priced.