Unrated and sub-investment grade bonds carry attractive yields but come with greater risks. The growing AUD high yield market now gives you the ability to truly diversify. We demonstrate this with a $175,000 portfolio that contains 17 unrated bonds whilst maintaining an excellent running yield of over 7.25%
A standard rule of investing is that higher return equals higher risk.
This is particularly true of high yield bonds (i.e. unrated and sub-investment grade bonds) when compared to investment grade bonds, as Figure 1 ‘Standard & Poor's five year probability of default by rating’ demonstrates.
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 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. Professionally managed high yield bond funds typically hold hundreds of individual positions.
This risk/return relationship is exponential, especially as the rating falls below BBB- (or into sub-investment grade territory). 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
When creating fixed income portfolios, three simple conclusions can be drawn from the above:
- The majority of your portfolio should be investment grade (see Safe Harbour Investment Strategies)
- The allocation to high yield bonds needs to be very well diversified to ensure you are not overly exposed to the failure or default of any single bond
- As risk increases you must ensure you are appropriately compensated via higher return
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, with bonds from 17 unrated over the counter bond issuers now available, and growing (and all with minimum parcels of $10,000), a truly diversified portfolio is possible.
Detailed below is a portfolio that simply allocates $10,000 face value to each of the 17 unrated issuers with a total spend of just over $175,000 (16 FIIG-originated bonds plus NEXTDC which was originated by the NAB). Obviously investors could choose to alter the portfolio to exclude names they do not like or already have exposure to, possibly via equities.
As the portfolio statistics below demonstrate, despite the very high level of diversification, returns remain high with an excellent running yield of almost 7.3% and a yield to maturity of over 6.7% and average trading margin of close to 4.2% (noting that all bonds are priced to maturity and the yields may differ slightly if some bonds are called at earlier dates).
In order to construct a balanced portfolio above, where there is an issuer with a fixed and a floating option, the floating has been chosen (i.e. G8, McPherson’s Limited and SCT). This equates to a 60% fixed and 40% floating portfolio.
Investors not concerned by the prospect of rising rates could increase returns by replacing these with the fixed lines. Further diversification is also possible by including any of the three fixed Qantas sub-investment grade bonds.
Conclusion
High yield bond investing requires a very different mindset to that of investment grade portfolios.
Until recently the AUD high yield market simply did not have enough bonds to enable true diversification, but this has now changed and investors are strongly encouraged to consider their portfolios and where high yield concentrations are seen, sell down some of those exposures and reinvest the proceeds in other high yield options to spread the risk.
Further detail on considerations for high yield investing can be found in the article ‘Managing risk in high yield bond investment’ written by Will Arnold on 22 May 2015 (see below for link)
Next week, we will look at combining a high quality/investment grade portfolio with a diversified high yield portfolio and compare the overall risk and return metrics.
All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.