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