As published in The Australian on 7 November 2017
High yield bonds are tempting but come with greater chances something could go wrong. This note gives some tips in getting the balance right between high yield and investment grade
The global bond market is a bit like an amazing buffet, so many bonds to choose from, which can make it difficult to work out how to invest
One way is to consider the risk you are prepared to take. Then determine your split between investment grade bonds: low risk, think ASX top 40 companies, with a very low chance of anything going wrong; and sub investment grade or high yield, being higher risk, with more chance that something could go awry.
With returns very low by historical standards, it’s easy to be tempted by the 5 to 10 percent per annum returns on offer from high yield bonds.
It’s important to understand the additional risks and the reasons you are being paid so handsomely. Very broadly, I’d suggest most investors target a 70 per cent allocation to investment grade and 30 per cent high yield bonds. But, some will have much higher allocations to high yield, happy with the equations, substituting the bonds for equities in their portfolios.
Investors in the higher quality investment grade bonds – rated AAA down to BBB- on the S&P rating scale – can expect the bonds to perform consistently; that is, pay interest every three or six months and repay face value at maturity. They make great defensive assets.
This is how bonds earn the ‘sleep at night’ description. Allocating a significant portion of your portfolio to investment grade lets you employ a set and forget or hold to maturity strategy with confidence. Standard and Poor’s, assesses the probability of default across global investment grade bonds over a five year period as 0.96 per cent. Australia’s record is even lower.
Default doesn’t mean loss, just that a payment has been missed. It may mean payment at a later date or eventual wind-up.
The downside is that current rates of return are relatively low for investment grade bonds.
Two bonds just rated investment grade, Qantas and Lend Lease with relatively short terms of less than three years, due to mature in April 2020 and May 2020 respectively, have yields of 2.88 per cent per annum and 3.17 per cent per annum. These household names are low risk with returns to match but aren’t the best rates on offer in the investment grade space. There are investment grade securities with returns around 4.5 per cent per annum, but are less well known, with one very out of favour outlier showing 6.5 per cent per annum.
Sub investment grade or high yield bonds – rated BB+ down to D step up in risk and also return. Most will also perform to expectations, but there may be unexpected events that cause prices to fall, adding volatility.
Careful analysis can reap rewards but the chance of something going wrong increases significantly. Standard and Poor’s assesses the probability of default across all global sub investment grade bonds over a five year period as 15.29 per cent – 15 times more than investment grade counterparts.
To take on that extra risk, investors need to do their homework and play close attention to the drivers of the company, profitability, cashflow and balance sheet, the debt levels and when debt or bonds become due for repayment.
How the bond fits into the group structure and where it sits in the debt maturity profile are factors. Other risks that need to be assessed include: regulation, competition, new competitors, disruptive technology, commodity prices and management, just to name a few.
There are few choices in the Australian market but if we skip across to the US, the most developed market, some big names issue sub investment grade bonds such as cosmetics company Avon and rental car company Hertz.
Avon has a fixed rate bond maturing in August 2022, showing a yield to maturity of 6.95 per cent per annum and it is rated BB- - three notches higher than the Hertz bond maturing in October 2024 at B-.
Surprisingly, the Hertz yield to maturity is practically the same at 6.94 per cent a year. The returns on both bonds are equity like and very appealing. But the fact that the Hertz bond yield is the same as Avon given its lower credit rating and longer term mean there’s more to investigate.
US denominated sub investment grade bonds have had terrific returns over the last 12 months, but are now trading in the tightest range in 20 years. Many companies are in relatively good shape, having borrowed at low rates for the coming years, reducing the risk of default.
The US companies are larger and more complex than the two Australian investment grade examples. High yield investors should expect volatility and, if we encounter another major stress event, also illiquidity. I wouldn’t classify them as set and forget or sleep at night investments.
Investors can’t be complacent and must keep track of developments over the lifetime of these bonds.
Bloomberg Barclays US Corporate High Yield Total Return Index
Source: Bloomberg