Thursday 28 September 2017 by Elizabeth Moran Trade opportunities

High yield bonds – risk assessment checklist

If you have a portfolio of high yield bonds, it’s worth trying to better define the risk associated with each bond and how those risks might cross over with other bonds in your portfolio

highyield

High yield bonds pay high returns for increased chance of volatility and loss, but that doesn’t mean they are ‘junk’. Rather, just like trolling around a second hand shop, you can find some gems, worth more than they seem. Companies may go on to perform strongly and the price of the bond rises as the credit margin contracts, providing investors with higher than expected gains - assuming interest rate expectations remain unchanged.

Of course, companies that issue high yield bonds can have unpredicted negative turns, sending prices lower.

Companies that are in this bracket typically have a greater probability of a negative credit event that could impact bond prices.

Below is a checklist taken from ‘The handbook of Fixed Income Securities’ by guru Frank J Fabozzi. A couple of factors have been taken off the list as they don’t pertain to the Australian market.

The more indicators that are negative, the greater the level of risk associated with the investment. The list is by no means exhaustive, rather meant to prompt possible risks that you may not have considered.

High yield checklist

  1. “CCC” or equivalent rated
  2. Project finance
  3. Fallen angel – companies with investment grade credit ratings that have fallen on hard times with a deteriorating balance sheet.
  4. 2nd or 3rd tier underwriter
  5. Small deal size <$250m
  6. Weak covenant package
  7. Recession prone industry
  8. Leverage >6x or >85% enterprise value
  9. Long duration > 10 years
  10. Highly cyclical industry
  11. Weak and/or distrusted management
  12. Previously defaulted or high risk default industry
  13. Current or projected negative free cashflow
  14. Little or no hard assets
  15. Dividend deal
  16. Middle market company
  17. Debt at holding company and structurally subordinated to other debt
  18. Down quarter and down year projected
  19. Lead underwriter is also an equity holder in the company
  20. Poor information flow or management contact
  21. Covenant violation and/or forecast in the next 12-24 months
  22. Significant refinancing required in the next two years

Source: Frank J Fabozzi “The Handbook of Fixed Income Securities” 2012

Which factors ring the loudest alarm bells?

Personally, I’m especially wary of bonds issued by a holding company and structurally subordinated to other debt.

Cyclical industries hitting hard times such as the US energy sector come to mind as does violation of covenants and/ or a credit rating downgrade. 

The debt maturity profile is also something I’d be continuously looking at – how much debt is due and when? Remembering that failure to pay interest and return face value at maturity could force liquidation. Bondholders would then look to their position in the capital structure and hope to get some funds returned to them.

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