Friday 21 April 2017 by Emma Jenkin At FIIG

How we manage risk in high yield bond portfolios

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High yield bonds play an important part in a portfolio, providing much needed higher income, particularly in a low interest rate environment. We explore key risks and other considerations of high yield bonds, as well as examine how the portfolio management team look after the Income Plus bond portfolio. 

Unrated and sub investment grade bonds – often called high yield bonds - carry attractive yields, but come with higher risk compared to investment grade bonds. Deciding to invest in these bonds increases overall portfolio risk. One way to mitigate against the higher risk is to have lower exposures to a greater number of bonds, compared to the investment grade allocation.

Until recently, it was difficult to diversify your high yield allocation as there were simply not enough high yield bonds in the Australian market, with demand outstripping supply. However, there are now 40 unrated over the counter bond issues available. FIIG’s DirectBond Service allows high yield bonds to be purchased from $10,000 per bond and makes 29 FIIG originated bonds available.

Managing a portfolio of 15 plus high yield bonds  may be a challenge for direct investors – our flagship bond IMA, the Managed Income Portfolio Service (MIPS) Income Plus program provides an alternative. MIPS’ portfolio diversity is aided by the DirectBond Service where a $250,000 portfolio can hold up to 25 bonds.

Small caps and high yield bonds

In many ways there are similarities between high yield bond investing and small cap share investing, where at any given time a portfolio of small caps will see some companies improving, some remaining stable and others experiencing some difficult periods. Small cap investors can generally expect there will be companies at different points in their cycle, but on a portfolio basis, expect the winners to outpace the losers. 
Looking 12 months ahead, it is rarely the same companies that are improving, remaining stable or facing troubles – hence the need to consider a diversified portfolio strategy as opposed to one based on company specific stock selection.

How the MIPS team assess risk

When the Portfolio Manager is considering investing in a high yield bond, he follows these steps:

  1. Performs an individual credit assessment, including detailed review of the business model, the balance sheet and historical performance.
  2. Reviews external research opinion, including equity research where available (for listed entities).
  3. Considers the business model under stress and the implications for debt servicing and repayment or refinancing upon maturity.
  4. Considers the addition of the credit to portfolio with regard to correlation to existing exposures and determines improvement of diversification in the portfolio
  5. When satisfied with the credit worthiness of the company, and that the bond meets the requirements of the mandate, decides to invest and places a bid

The flagship Income Plus program can invest up to 75% of funds in high yield bonds. The current portfolio has 18 different high yield bonds and 13 other bonds for a $500,000 investment (portfolios with less than $500,000 will not always hold all 31 bonds).  The MIPS team diversifies by spreading capital across a range of high yield companies as one way of mitigating risk for this sub section of the fixed income asset class.

Three key risks for high yield bonds

1. Credit risk

The greatest concern with individual high yield bonds is credit risk – the chance that the issuer could default on the principal or interest payments. Unlike assessing share investments, where the focus is on the probability of profit and growth prospects to drive share price/investor returns, credit assessment is more concerned with cashflow and the survivability of the company and what the recovery is likely to be in default, regardless of whether it’s shrinking or growing.

Figure 1 illustrates the probability of default in a five year period by ratings band.
Standard & Poor’s five year probability of default by rating

Figure 1
Figure 1

Source: Standard & Poor's 2015 Annual US Corporate Default Study, FIIG Securities

As you can see, the risk and return relationship is exponential, steepening as the credit rating falls below BBB- into the sub investment grade area. The average US investment grade rating probability of default over five years is 1.19%  whereas the average for sub investment grade ratings is 14 times higher at 16.9%. Hence the great importance the market places on the difference between the two. However, when considering the default rate it is important to also consider the recovery rate (the amount of money return out $100) which averages 44% for senior unsecured debt.
Another way to look at this data is to compare four common credit rating points over a five year horizon: 

  • A – 0.71% probability of default 
  • BBB – 1.88% probability or 2.7 times more likely to default than single A
  • BB – 7.70% probability or 10.8 times more likely to default than single A
  • B – 20.08% probability or 28.3 times more likely to default than single A

2. Liquidity risk 

Liquidity risk arises from situations in which a security cannot easily be sold at, or close to, its market value.  Liquidity risk is typically reflected in unusually wide bid-ask spreads or large price movements.

Liquidity risk is very different from a drop of price to zero, which indicates the market thinks the asset is worthless. Instead, there are simply limited potential buyers in the market at that point in time. This is why liquidity risk is usually found to be higher in low volume markets and is exaggerated during times of high market stress, such as the GFC. Generally speaking, high yield bonds exhibit higher liquidity risks than investment grade bonds. A risk averse investor would naturally want to be compensated for increased liquidity risk.

3. Volatility 

High yield bonds typically display greater price volatility than bonds with investment grade credit ratings.  High yield prices are more sensitive to the economic and corporate outlook, typically underperforming during a downturn and outperforming during a recovery phase compared to other fixed income classes.

Other considerations

Structuring and ranking in liquidation

In the event of company windup, bondholders have an advantage as they are paid first – before preferred and common shareholders. However, other debt may rank in priority of payment to your bond holdings so it is important to be aware of the full capital structure.

High yield bonds also have a variety of protections, known as covenants, aimed at keeping as much cashflow as possible available to service debt obligations. This may be achieved by limiting the amount of debt, or restricting payments such as dividends to shareholders.

Correlation

High yield bond returns are not highly correlated with investment grade bonds because yields are less vulnerable to changing interest rates and can help smooth overall portfolio returns. 

Diversification does not insure against loss, but it can help decrease overall portfolio risk and improve the consistency of returns. Further, correlation amongst industry concentrations for high yield bonds can be high, and we suggest a good spread of sectors be included in a balanced portfolio.

MIPS Income Plus Program 

The Income Plus Program is managed by the Managed Income Portfolio Service (MIPS) team of professional fixed income managers and can invest up to 75% in high yield bonds. MIPS Income Plus has historically held a range of between 40% and 75% exposure to high yield bonds, currently at 61% with the balancing 39% held in investment grade bonds. For new investors, the current anticipated Income Plus portfolio yield is 6.06% pa , with 61% of the portfolio in high yield bonds. Investors hold up to 31 individual bonds with 18 high yield names.

The 18 high yield bonds held in the Income Plus program are unrated except for La Trobe RMBS (BB), and as a result these bonds will display a range of risks in the sub investment grade spectrum. The high yield bonds provide additional yield with an average credit margin of 4.88% for the 18 bonds. This compares to a 2.06% credit margin for the 13 investment grade bonds in the portfolios.

Is the return offered on the high yield bonds sufficient for the risk?

It is difficult to quantify the return given risk as the high yield bonds are not rated, so it is not possible to use the S&P tables with certainty. However, the tables can be used to try and quantify the amount of annual income required to compensate investors versus historical loss rates at different rating levels. 

To make the calculations, we use a few simplifying assumptions:

  • Historical defaults are replicated in the future
  • The S&P US default  rates are used as a proxy for the newer Australian high yield market which has limited data, see Figure 1
  • Assume the S&P US recovery rates of 44% for senior unsecured debt applies

This is then applied to the Income Plus portfolio where 61% of the bonds are high yield. 

To illustrate the calculation, take the BB rating level with a cumulative default rate over the last 5 years of 7.7% (see Figure 1). This is divided by 5 to get an annual default rate of 1.54% and if we assume this is the average rating  of Income Plus program we apply this to the 61% that is invested in high yield bonds to get the annual default rate of 0.94% (61% x 1.54%). The recovery rate based on historical S&P data is 44% (that is you receive 44c in the $1 on bonds that default) which results in an annual predicted loss of 0.53% for the Income Plus program. The high yield bonds in the program currently pay a credit margin of 4.88% per annum offering coverage of 9.3x the forecast loss rate. 

Figure 2 outlines the annual income required across the ratings range from B- to BB+ assuming this is the average for the high yield bonds for the current Income Plus program:

Figure 2
Figure 2
Source: S&P, FIIG Securities

The analysis outlines the mathematical calculation to try and assess the risk of holding high yield bonds, based on historical default and recovery rates. Clearly, historical default and recovery rates are not necessarily going to be replicated in the future and we have used a series of assumptions that may or may not represent the experience in the relatively new Australian high yield market. 

But the table shows that if the historical default and recovery rates experienced in the US over the last five years were to apply to the next five years in Australia, an investor in the Income Plus program would be more than compensated in annual income across the ratings range. The coverage ranges from 2.4 times at B- and up to 14.5 times at BB+.

None of us know if there is going to be a default in the Australian high yield market, but the S&P default rate table illustrates the increased risk of investing in high yield. Diversification across issuers, sectors, bond types, maturities and individual companies - with smaller face values than the investment grade part of the portfolio - will help protect your overall portfolio. 

The question you need to ask yourself is “Do I hold enough high yield bonds with enough diversity to effectively spread the risk?” The Income Plus Managed Income Portfolio Service with up to 18 bonds and maximum 4% exposure achieves very good high yield diversification.

The key portfolio metrics of Income Plus are shown in Figure 3.

Figure 3a
Figure 3b
Figure 3
Source: FIIG Securities
Note: Returns quoted are accurate as at 3 April 2017

Figure 4 details the Income Plus Example Portfolio, demonstrating the diversity and maximum high yield allocation of 4% per bond.

Figure 4
Figure 4
Source: FIIG Securities
Accurate as at 13 April 2017 but subject to change

Conclusion – Diversification is key to portfolio risk management

While credit risk is the greatest concern with individual bonds, diversification is paramount when managing a portfolio of high yield bonds.  

The MIPS team are professional bond managers. When managing high yield in the Income Plus and Core Income portfolios, they spread the risk across many bonds so that a potential value or liquidity issue, or even default from a particular bond, is small in the context of the overall investment portfolio.  Moreover, any loss of value is more likely to be offset by the excess returns made on the remaining performing assets in the portfolio over time. 

The Income Plus program is managed based on the fundamental principal of diversity of bond holdings, as demonstrated by 31 bonds – 18 of which are high yield – with a maximum allocation of 6% to any bond or 4% per high yield bond, generating an attractive overall yield of 6.06%.

Until recently, the Australian high yield bond market did not have enough bonds to allow investors to truly diversify – but this has changed with FIIG offering investors high yield bonds via the DirectBond Service. We encourage you to reassess your high yield bond allocation and also consider the benefits of outsourcing your bond portfolio management to the MIPS team.

Please call 1800 01 01 81 or your local dealer to learn more.

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