For our clients and regular readers of The WIRE, you’ll be all too familiar with the investment case for corporate bonds versus:
For the majority of corporate bonds it is mandatory for companies to pay coupons, whereas equity dividends are discretionary. As a nation, Australia’s portfolio allocations to fixed income – and in particular corporate bonds – still significantly lags behind those of other developed countries, yet we can see that increasing the allocation can help to diversify a portfolio’s risk exposures and potentially increase portfolio income levels.
But as we look to corporate bonds as a way to increase our portfolio allocations to fixed income, how do we know which bonds are right for us? How should we approach our consideration of the risks and rewards?
One of the key things we like to focus on when assessing corporate bond opportunities is how to tilt the odds in our favour.
Unlike equities with their (theoretical) infinite upsides, bonds mature at 100% of their face value (par) – but if they default, can recover significantly less than par (theoretically as little as 0%). That sucks, right? In a default scenario, whatever you are recovering as a bond investor, you can bet your boots that you would not have been in a better position had you invested in the equity instead, and in most instances, end up substantially worse off. That’s what we mean by “a more senior position in the capital structure”.
Given that your upside is limited, the starting point of a bond investment is that the odds are stacked against you. So we like to look for bond investment opportunities that allow you to make the odds work in your favour.
Bond prices substantially below par
One way is to look for bonds with cash prices below par. Recall that most bonds mature and pay you back 100% of face value. If you buy a bond with a significant discount to par, providing all goes well, you will receive all the scheduled coupon payments until maturity, and you will get paid back the full face value of the bond – thereby gaining income and capital. Buying a bond that trades at a lower capital price also reduces the potential downside in a default scenario, versus buying a bond at or above par. Of course, bonds don’t just trade below par for no reason, so we also like credit stories where a lot of headwinds are behind the company, and where management is demonstrating clear and credible efforts to turn things around.
Higher yields also help to tilt the odds in your favour
As yields move higher, the marginal negative price impact of another little widening in yields diminishes, and vice versa. All else being equal, a higher yielding bond will exhibit “better convexity” than a lower yielding bond, as it affords better cushioning to protect against further downside moves.
All things being equal, bonds with high yields coupled with low capital prices offer more attractive risk-reward then equity, as the downside is likely more limited than an equity investment, but the upside can still remain significant if the right fundamental drivers are in place.
Credit investments that are based on turnaround stories benefit from higher yields, as investors get paid a higher rate of return to wait for the turnaround to happen. Higher yielding bonds are also likely to be less sensitive to interest rate moves as a greater proportion if the yield represents credit risk. A ten year bond with a 10% yield will have lower interest rate sensitivity than a ten year bond with a 3% yield. Interest rate sensitivity is a key consideration for any fixed income portfolio, especially as the global rate cycle begins to turn.
Other ways to limit the downside
Consider assets, structure and covenants. Businesses with large tangible asset bases in industries where those assets are likely to be attractive to peers offer better recovery prospects in a default scenario. Those recovery prospects are strengthened by the bonds being issued out of operating entities where operating assets usually sit, and by strong security language and covenants that define your rights to claim against asset values and protect your position as a bond investor.
Financial flexibility is another important factor to consider, especially when considering investments in high yield corporates. Higher yields are usually indicative of higher risks, and one of those risks could be access to sources of liquidity (cash, overdrafts, revolving bank facilities) and financial levers to preserve cashflow (ability to turn off dividends). For corporate turnaround strategies to be credible, a necessary but not sufficient condition is access to sufficient liquidity, often referred to as a “liquidity runway”, to allow the company to complete the planned turnaround.
Turnaround stories
Let’s talk about some real life examples. In late 2015, Elizabeth Arden bonds traded to a low of 55% of face value, which equated to over 17% yield. This was as a result of a period of earnings erosion due to operational difficulties, exacerbated by the poor department store retail environment in the US.
The company was starting to show signs of turnaround, significant efficiency gains, cost rationalisation, and management focus on distribution strategy, but sequential results were still choppy and the market (both equities and bonds) were reluctant to believe in the turnaround story. However, a sum of the parts analysis on the various parts of the business implied that even in the event of a distressed sale to a peer, bond recoveries would likely be close to par.
Further, Elizabeth Arden still had access to a sizeable revolving bank facility and some cash on the balance sheet, providing the liquidity runway it needed to execute on its turnaround strategy. In July 2016, Revlon announced its intention to acquire Elizabeth Arden, citing significant potential value in revenue and cost synergies. Elizabeth Arden bondholders were able to put their bonds back to the issuer at 101% of face value.
In late 2015, various sub investment grade rated European cable operators were able to issue fairly long dated bonds with low coupons because of the low interest rate environment, but due to widening yields into 2016, many of these bonds traded significantly below par. However, at capital prices in the low to mid 80% range, investors started to question whether such deep discounts were warranted given the strong network asset base that most of these companies had, which limited further weakening in the bonds despite adverse moves in interest rates. Since the European Central Bank (ECB) extended its Quantitative Easing (QE) programme to the purchase of corporate bonds, European corporate yields have once again compressed and these bonds now all trade comfortably above par.
It is always important to identify the downside risks in any investment, but by focussing on opportunities for upside potential, we will help shift the odds of bond investing in our favour.