Tuesday 24 July 2018 by William Arnold Education (advanced)

Managing risk in your high yield bond portfolio

High yield bonds can 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 associated risks is to diversify. We explore key risks and other considerations for building and managing a portfolio of high yield bonds.

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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 this has changed. FIIG alone has raised over AUD2bn in high yield debt from 49 issues.

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 rating agencies S&P and Fitch, or ‘Ba1’ by Moody’s.

In many ways, there are similarities between high yield bond investing and small cap share investing. At any point in time, a portfolio of small caps will typically see some companies improving, some remaining stable and others experiencing occasional difficult periods. Further, if you look 12 months ahead, it is rarely the same companies that are improving, stable and/or facing difficulty. 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 chart below illustrates the probability of default over a one and three year time period by ratings band.

It’s important to note however that a default as defined by the ratings agencies can have a wider meaning than simply failing to meet interest or principal payment obligations by the due date. In fact, this does not necessarily mean the investor lost money.

If the terms and conditions are renegotiated or if securities are exchanged in a situation the rating agency considers a restructure this is recoded as a “default”. For example by accepting substitute instruments with lower coupons, longer maturities, or any other diminished financial terms.

S&P Global Ratings one and three year probability of default by rating (Globally)



Source: S&P Global Ratings 2017 Annual Global Corporate Default Study, FIIG Securities

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 usually underperform during a downturn and outperform during a recovery phase (compared to other fixed income classes).

As you can see, the risk/return relationship is exponential, steepening as the rating falls below “BBB-“ into the sub investment grade area. The global average investment grade rating probability of default over one year is 0.10% whereas the average sub investment grade is 3.75%.

The probability of default also increases over a longer time horizon. Over a three year period the global average investment grade default rate increases to 0.45%, while the average sub investment grade ratings is 10.39%.

We also note that the above chart is based on global statistics, including higher risk jurisdictions which inflate the numbers. The Australian default statistics are significantly lower than the global statistics, in part due to our relatively stable economy and almost exclusively investment grade market.

In 2013, an Australian company recorded its first default since the beginning of the GFC, with CCC+ rated Mirabela Nickel Ltd missing an interest payment on its USD loans. In 2016, two Australian companies went into selective default – Atlas Iron (Atlas), an independent iron ore company and Barminco Holdings (Barminco), whose core business is mechanised underground mining services. Both companies were subsequently rerated and continue to operate.

While there is a clear correlation between credit rating and default probability, this is only part of the story. While investment in the shares of a company going into bankruptcy would generally lose its entire value, investors in a defaulted bond would typically recover some of their investment. It is generally accepted that a bond that has the benefit of security over the assets of a company would generally recover between 60% to 80% of its face value following a default. This is because the assets of the company would be available to cover creditors’ claims, with senior secured bondholders standing at the front of the queue (while shareholders would be last in that queue).

2. Liquidity risk 

Another key risk is liquidity. Liquidity risk arises from situations where 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 when the asset price drops to zero (where the market is saying that the asset is worthless). Instead, there are limited potential buyers in the market at that time. This is why liquidity risk is usually higher in low volume markets and exaggerated during times of high market stress, such as the GFC. Generally speaking, investment grade bonds have better liquidity compared to high yield bonds. A rational investor would want to be compensated for increased liquidity risk.

Importantly, liquidity risk is only relevant for investors seeking to exit a position. While the price of a bond may vary at any point in time, this does not affect the company’s obligations to pay interest and principal, based on the face value of the bonds.

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 usually underperform during a downturn and outperform during a recovery phase (compared to other fixed income classes).

Other considerations

Structuring and ranking in liquidation

In the case of insolvency, debt securities have an advantage over equity investments. 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 aimed at keeping as much cashflow as possible 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.

Due to 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, so it is suggested a good spread of industries be included in a balanced portfolio.

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 spread risk and protect your portfolio. Professional high yield fund managers will spread the risk across many bonds so that a potential value, 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.

Example bond portfolio

The following table below is an example of a bond portfolio with a high yield component.  The portfolio has about a 60% exposure to investment grade bonds, and a smaller 40% allocation to high yield bonds. The portfolio is relatively conservative with a yield to maturity of 5.26%pa and a 5.58% running yield.

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 as seen in the pie charts below.

IAB: Indexed Annuity Bond, CIB: Capital Indexed Bond, FCB: Fixed Coupon Bond, FRN: Floating Rate Note, NR: Non Rated
Source:  FIIG Securities

Glossary

Yield to Maturity

The return an investor will receive if they buy a bond and hold the bond to maturity. It refers to the interest or dividends received from a security and are usually expressed annually or semi-annually as a percentage based on the investment's cost, or its face value. Bond yields may be quoted either as an absolute rate or as a margin to the interest rate swap rate for the same maturity.

It is a very useful indicator of value because it allows for direct comparison between different types of securities with various maturities and credit risk.

Note that the yield and coupon are different.

Running Yield

The interest rate on an investment expressed as a percentage of the capital invested. It takes no account of the capital accumulated. It is used to describe the income investors receive from their portfolio as a percentage of the invested capital.

Yield to Worst

Yield to worst tells you what the lowest yield would be, if the company decides to repay your bond at the worst possible time. This could be on the maturity date or any early call dates.

Yield to worst could be the same as yield to call if the first call is the worst outcome for you; it could be the same as yield to maturity if you are worst off when the company chooses not to call at all; or it could be lower than both of them where you are worst off if the company calls on the second or subsequent call date.

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