Credit ratings help investors interpret risk and return. In this note we compare credit ratings, yield and probability of default for 36 US high yield bonds
The high yield USD market is mature, offering a huge assortment of bonds compared to its fledgling AUD counterpart and for investors chasing yield, can offer some exciting opportunities. High yield is classified as any bond that is sub investment grade, with BBB- being the lower boundary of investment grade. Consequently, any bond rated BB+ or below - or that does not have a credit rating is regarded as high yield.
The question becomes, how to differentiate between the bonds on offer? An easy preliminary assessment might be to analyse the yield on offer given the credit rating.
As credit ratings decline and yields increase, it’s even more important that you conduct a thorough analysis to make sure you are comfortable with the risks involved. Outliers are often outliers for a reason, and as yields increase, it’s even more important to make sure you are comfortable with the risks involved. Credit ratings can also be wrong, as they are based on a set of historic accounts, among other reasons.
Table 1 and Table 2 provide an overview on the bonds FIIG offers in the high yield universe and the perceived risk, as qualified by the S&P credit rating. Taking the very basic analysis one step futher, I’ve added in the S&P probability of default for the term of the bond#.
Table 1 shows USD bonds we make available in the Standard and Poors ‘BB’ range. The order is based on expected maturity dates, with the shortest term bond at the top of the table to the longest dated bond at the end. Maturities range from around 18 months out to 24 years and demonstrate the depth of the market.
These sub investment grade rated bonds have increasing probabilities of default compared to their investment grade counterparts discussed last week and a corresponding range of higher yields. Most of the bonds are fixed rate, so while credit risk is increasing as you move down the credit rating scale, there is also increasing interest rate risk with the longer dated bonds.
Surprisingly, there are a number of bonds with a yield to worst of less than 3%pa and the BB rated James Hardie International maturing in approximately 5.5 years has a very low YTW of 2.17%pa. It’s definitely a bond to consider selling if you hold it.
McDermott International has a senior BB rated bond maturing in June 2021 and with a YTW of 5.79%pa, seems to be the stand out opportunity of the shorter dated issues.
If you hold either the Bluescope of the Kinross that have similar maturities, yielding 2.76% and 3.06% respectively, switching out of these and into McDermott looks like a good trade.
Only two bonds show double digit returns, both are from Talen Energy Supply. If we consider the shorter dated Talen bond due to mature in July 2022 with a YTW of 12.23% and compare it to the Hertz bond with the same credit rating and similar maturity, it’s yield is almost double that of the Hertz bond which is 6.91%pa.
Having been an analyst for many years, the large discrepancies are like a red rag to a bull. Investors will be paid those returns for a reason and as an investor you need to understand why and like any investment, work out if the reward compenstaes for the risk involved. The credit rating may be over stated.
USD bonds rated in the 'BB' range
Table 1
Source: FIIG Securities, S&P Global
Probability of default percentages from S&P's Corporate Default Study and Rating Transitions report
Prices accurate as at 10 July 2017 but subject to change
Graphically, a selection of bonds is shown in Figure 1. It’s important to note the issues cannot be directly compared given a range of credit ratings, but it does provide a framework for comparison.
Figure 1
Source: FIIG Securities
Table 2 shows the bonds in the S&P ‘B’ range which range from B+ to B-. These are higher risk than those in the ‘BB’ range, and you’ll notice yields are generally higher as is the probability of default. The table only includes bonds rated B flat and B- and have a shorter term than the BB rated bonds in Table 1. It’s worth noting the steep rising in the probabilities of default, especially for the B- rated bonds. The Kindred Healthcare January 2023 maturity has a probability of default of 28.53%, while the Hertz October 2024 bond is at 30.21%.
USD bonds rated in the 'B' range
Table 2
Source: FIIG Securities, S&P Global
Probability of default percentages from S&P's Corporate Default Study and Rating Transitions report
Prices accurate as at 10 July 2017 but subject to change
Figure 2 shows a selection of bonds graphically. It’s important to note the issues cannot be directly compared given a range of credit ratings, but it does give you a framework for comparison.
Figure 2
Source: FIIG Securities
A couple of things to keep in mind
- Default doesn’t necessarily mean investors lose money but this may take significant time to determine
- The lower the credit rating, the greater emphasis on asset values and possible recovery rates for investors
- The credit rating agencies sometimes get it wrong. Anyone that followed markets throughout the GFC may remember quite a few structured collateralised debt obligations (CDOs) that were rated AAA which defaulted
- Bonds that seem to offer good relative value may be in riskier industries for example oil and gas exploration or mining services
- The longer the term to maturity, the greater the risk, thus the higher returns on offer for longer dated securities
- Practically all the bonds on the list are fixed rate and the US has started to raise rates again. That can mean fixed rate bond prices decline
- Unhedged foreign currency positions assume extra risk which can also work in favour of the investor if the Australian dollar falls, but can reduce returns if it rises
- For those investors wanting a pure currency play, the best credit quality bonds, that is the lowest risk bonds, that somewhat negate credit risk, offer the best possible outcome
For more on the S&P default rate table, see last week’s article “Quantifying the risk of bonds with S&P credit ratings
”.
Credit ratings give an indication of risk and should not be relied upon.
Investors need to do their homework before investing, including reading up on the company, its management team, strategy and assessing its financial position. It is also important to consider the industry the company is in and any future projections.
Last week we published a similar note on investment grade USD bonds. Please scroll to the end of the note for a link.
For more information, please call your local dealer.
Note: Pricing is accurate as at 10 July but subject to change
#The S&P Probability of default tables only extend to 15 years. If the bond has a longer term to maturity, we’ve assumed the 15 year probability of default rate.