High yield bonds play an important part in a portfolio, providing much needed higher income, particularly in a low interest rate environment. The most important way to hedge against those risks is to diversify. We explore key risks and other considerations as well as list some of the high yield bonds available
Unrated and sub investment grade bonds carry attractive yields but come with higher risk compared to investment grade bonds. As the risk profile increases portfolio diversity becomes more important. Until recently, it was difficult to diversify your high yield bond allocation as there were simply not enough high yield bonds in the AUD market. However there are now 24 bonds from 21 unrated, over the counter bond issuers with minimum parcels of $10,000.
By way of background, unrated and sub-investment grade bonds are typically referred to as high yield bonds which means they are not rated or hold a rating of BB+ or below by Standard & Poor’s or Fitch Ratings, or Ba1 or below by Moody’s Investors Service.
In many ways there are similarities between high yield bond investing and small cap share investing, where at any point in time a portfolio of small caps will typically see some companies improving, some remaining stable and others experiencing some difficult periods. Small cap investors will generally expect that there will be companies at different points in their cycle but on a portfolio basis, expect the winners to outpace the losers. Further, if you look 12 months ahead, it is rarely the same companies that are improving, stable and facing troubles. Hence the need to consider the strategy on a diversified portfolio basis as opposed to one based on company specific stock selection.
Three key risks
1. Credit risk The largest concern with individual bonds is credit risk, in other words, 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, regardless of whether it’s shrinking or growing.
The following chart illustrates the probability of default in a five year period by ratings band.
Standard & Poor’s five year probability of default by rating
Source: Standard & Poor's 2015 Annual Global Corporate Default Study, FIIG Securities
As you can see, the risk/return relationship is exponential, steepening as the rating falls below BBB- or into the sub investment grade area. The average investment grade rating probability of default over five years is 1.03% whereas the average of the sub-investment grade ratings is 15 times higher at 15.49%. Further, the lower the rating, the lower the recovery in a default scenario. Hence the great importance the market places on the difference between the two.
Another way to look at this data is to compare four common credit rating points:
- A 0.54% probability of default over a five year time horizon
- BBB 1.60% probability or 2.9 times more likely to default than single-A
- BB 7.31% probability or 13.5 times more likely to default than single-A
- B 19.53% probability or 36.2 times more likely to default than single-A
2. Liquidity risk Another key risk is liquidity. 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 (where the market is saying that 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 those bonds with investment grade credit ratings. High yield prices are more sensitive to the economic/corporate outlook and will typically underperform during a downturn and outperform during a recovery phase (compared to other fixed income classes).
Other considerations
Structuring and ranking in liquidation
Debt securities have an advantage over equity investments if a company goes into liquidation as bondholders would be paid first (followed by preferred shareholders then 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 bondholder protections typically aimed at keeping as much cashflow as possible available to service the obligation. This may be achieved by limiting the amount of debt, or restricting payments such as dividends to shareholders.
Correlation
Another item to note in high yield bond investing is that bond returns do not correlate well with either investment grade bonds or shares. Because yields are higher than investment grade bonds, they are less vulnerable to interest rate shifts, especially at lower levels of credit quality. Because of this low correlation, adding high yield bonds to your portfolio can reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation. Diversification does not insure against loss, but it can help decrease overall portfolio risk and improve the consistency of returns. On the flip side, correlation amongst industry concentrations for high yield bonds can be high and as such it is suggested a good spread of industries be included in a balanced portfolio.
List of AUD high yield bonds
Until recently, it was difficult to diversify your high yield bond allocation as there were simply not enough high yield bonds in the AUD market. However, there are now 24 bonds from 21 unrated over the counter bond issuers available, and growing (and all with minimum parcels of $10,000). The following table details these bonds.
| Issuer | Bond type | Maturity | Yield | Running Yield |
| 360 Capital Investment Management Limited | Fixed | 19/09/2019 | 6.46% | 6.81% |
| Adani Abbot Point Terminal Pty Ltd | Fixed | 29/05/2020 | 10.73% | 7.18% |
| Adani Abbot Point Terminal Pty Ltd* | Fixed | 01/11/2018 | 9.40% | 6.25% |
| Axsesstoday Group * | Floating | 09/10/2021 | 8.98% | 8.77% |
| Capitol Health Limited * | Fixed | 12/05/2020 | 8.25% | 8.25% |
| Cash Converters International Ltd | Fixed | 19/09/2018 | 7.76% | 7.92% |
| CBL Corporation Limited | Fixed | 17/04/2019 | 6.01% | 7.78% |
| CML Group Limited * | Fixed | 18/03/2022 | 7.58% | 7.87% |
| CML Group Limited * | Floating | 18/05/2021 | 7.52% | 7.41% |
| Dicker Data Limited | Floating | 26/03/2020 | 6.76% | 6.68% |
| G8 Education Limited | Fixed | 07/08/2019 | 6.63% | 7.43% |
| G8 Education Limited | Floating | 03/03/2018 | 6.38% | 6.24% |
| IMF Bentham * | Fixed | 30/06/2020 | 7.19% | 7.34% |
| Impact Group Aus Pty Ltd * | Fixed | 12/02/2021 | 8.34% | 8.46% |
| Integrated Packaging Group Pty Ltd * | Fixed | 29/09/2019 | 7.06% | 7.25% |
| Mackay Sugar Limited | Fixed | 05/04/2018 | 5.92% | 7.08% |
| McPherson's Limited | Fixed | 31/03/2021 | 7.03% | 7.08% |
| McPherson's Limited | Floating | 31/03/2019 | 6.62% | 6.60% |
| Moneytech Finance Pty Ltd | Floating | 17/04/2022 | 6.88% | 6.89% |
| NextDC Ltd | Fixed | 16/06/2019 | 6.08% | 7.59% |
| Plenary Bond Finance Unit Trust | Fixed | 16/06/2021 | 5.85% | 7.08% |
| PMP Finance Pty Limited * | Fixed | 17/09/2019 | 6.53% | 6.45% |
| SCT Logistics * | Fixed | 24/06/2021 | 7.06% | 7.46% |
| SCT Logistics * | Floating | 24/06/2019 | 6.57% | 6.68% |
| Sunland Capital Pty Ltd * | Fixed | 25/11/2020 | 7.47% | 7.53% |
| W A Stockwell * | Fixed | 29/06/2021 | 7.62% | 7.72% |
*Available to wholesale investors only
Example bond portfolio
The following table gives an example of a bond portfolio with a high yield component. The portfolio has about a 75% exposure to eight investment grade bonds, and a smaller 15% allocation to five high yield bonds. The portfolio is relatively conservative with a yield to maturity of 5.58% and a 5.03% running yield.
Example bond portfolio | Security | Security type | Rating* | Sector | Portfolio weight | Cost value | Yield to maturity | Running yield |
| Royal Women’s Hospital 30Jun33* | Index Annuity | Inv. Grade | Infrastructure | 17.9% | $187,096 | 6.11% | 4.30% |
| AGN-ILB-3.04%-20Aug25* | Capital Indexed | Inv. Grade | Energy | 13.1% | $135,631 | 5.15% | 2.95% |
| Sydney Airport 3.12%-20Nov30 | Capital Indexed | Inv. Grade | Infrastructure | 11.7% | $122,363 | 5.99% | 3.26% |
| Qantas-7.75%-19May22 | Fixed Rate | Inv. Grade | Corporate | 11.2% | $118,999 | 4.76% | 6.71% |
| Glencore-4.50%-19Sep19* | Fixed Rate | Inv. Grade | Resources | 9.2% | $95,739 | 6.07% | 4.72% |
| Sungrp-BBSW+2.05%-16Dec24* | Floating Rate | Inv. Grade | Infrastructure | 7.7% | $80,424 | 4.76% | 4.38% |
| PRAECO-7.132568%-28Jul20c | Fixed Rate | Inv. Grade | Infrastructure | 7.3% | $75,740 | 4.98% | 6.59% |
| JEM-6.637%-28Jun18c | Fixed Rate | Inv. Grade | Infrastructure | 7.1% | $74,967 | 2.45% | 6.33% |
| CBL-8.25%-17Apr19 | Fixed Rate | Non-IG | Insurance | 3.1% | $31,874 | 6.01% | 7.78% |
| Cash Converters 7.95%-19Sep18 | Fixed Rate | Non-IG | Corporate | 2.9% | $30,379 | 7.76% | 7.92% |
| SCT-BBSW+4.40%-24Jun19* | Floating Rate | Non-IG | Corporate | 2.9% | $30,268 | 6.58% | 6.68% |
| Dicker Data +4.40%-26Mar20 | Floating Rate | Non-IG | Corporate | 2.9% | $30,225 | 6.77% | 6.68% |
| G8 Education+3.90%-3Mar18 | Floating Rate | Non-IG | Corporate | 2.9% | $30,136 | 6.39% | 6.24% |
| | | | | | $1,036,237 | 5.58% | 5.03% |
Yields and margins on inflation linked assets are inclusive of an assumed 2.50% average inflation rate.
*Ratings are available to wholesale investors only
The portfolio is also well diversified by coupon, security type, industry and ratings.
IAB: Indexed Annuity Bond, CIB: Capital Indexed Bond, FCB: Fixed Coupon Bond, FRN: Floating Rate Note, NR: Non Rated
Source: FIIG Securities
Conclusion - Diversification is key to portfolio risk management
While credit risk is the largest concern with individual bonds, diversification is paramount when managing the risk profile of the overall portfolio. When looking to the unrated or high yield bond market where the various risks are higher, diversification is critical to spreading risk and protecting your portfolio. Professional high yield fund managers will 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 should be more than offset by the excess returns made on the remaining performing assets in the portfolio over time.
Until recently the AUD high yield market simply did not have enough bonds to enable true diversification, but this has now changed and we encourage you to reassess your portfolio.