High yield bonds provide high returns but can act more like the underlying equity. So, while the rewards can be impressive, the bonds need monitoring. It’s worth assessing when might be a good time to sell
There are many reasons to like high yield bonds aside from the higher returns on offer. They are often great for:
- Diversification - away from core equity holdings
- Potential upside – as they can trade at substantial discounts
- Accessing larger, more liquid markets – particularly the US, the largest global high yield bond market
Investment grade versus high yield bonds
High yield bonds, as judged by the credit ratings agencies, are perceived to be lower credit quality compared to investment grade bonds.
Investment grade bonds by contrast are low risk, so don’t need too much ongoing monitoring. They generally perform as expected and if you are a set and forget investor, these bonds would suit you. High yield bonds have different characteristics and need regular review and monitoring. They can act more like the underlying share of the company issuing them and pay higher returns because they have higher risks.
This is partly why we suggest smaller holdings of high yield bonds. If anything goes wrong, you don’t want to be reliant on the capital or liquidity of any single high yield holding. If, in the worst case scenario you end up losing some or all of the value of the investment, then the loss shouldn’t materially impact the overall value or return of your portfolio.
Most investors are more comfortable making the decision to buy a bond than the decision to sell it.
Here are three reasons you might consider selling a high yield bond (or investment grade bond for that matter):
- The credit worthiness has altered
- There’s been a change in relative value, that is the risk and reward is out of kilter
- Management fails to meet expectations
1. Credit worthiness has altered
Analysis of a high yield company needs to be ongoing. There’s a greater chance something could go wrong and the likelihood of surprises to the downside. You need to have an idea of how much of the unknown you will tolerate and if you have confidence in the management, as they should be issuing regular updates to help keep investors’ nerves at bay.
Any significant deterioration in the issuer and thus increased risk of default should prompt you to re-evaluate your decision to hold the bond. However, some investors that are happy to accept very high risk bonds may ultimately think it’s time to add more of the security to their portfolio.
Equally, an improving credit outlook and rising price of a high yield bonds might also be a reason to sell. For example, the Qantas 2022 fixed rate bond was issued with a high yield of around 7.75% per annum. The credit has improved and is now rated investment grade. Its current yield to maturity is circa 3.56% per annum and capital price around $113.51. It’s no longer a ‘high yield’ bond and if that was one of the reasons you bought the bond, you might be better selling and reinvesting elsewhere.
The more proactive you are, the higher your likely yield as you maximise returns, minimise capital declines and default losses.
A word of warning – do not rely on credit ratings. They are a useful guide as to the perceived credit worthiness of a company but they can be slow to react to changes, both positive and negative, creating opportunities and catching out unwitting investors.
Personally, I wouldn’t want to hold a bond going into a work out situation. It can take years to sell assets and have funds returned to you, in other words an illiquid position. Any hint of a steadily deteriorating position, I’m happier accepting a quantifiable loss than waiting for the lawyers and other creditors to slug it out.
2. A change in relative value
A bond doesn’t have to be near default to consider selling.
Consider a big debt funded acquisition, or a declining industry that you expect to deteriorate faster than the market does, or that a valuable patent is due to expire. There are a host of reasons why the relative value may not be appropriate and it is wise to reassess the security.
As already mentioned, changes don’t have to be negative to consider selling a high yield bond. An improving market or credit worthiness of the company might be reflected in higher bond prices and lower yields. At this stage, high yield investors need to question further upside potential, ask themselves if the bond still satisfies the portfolio’s objectives and consider taking some profit and reinvesting elsewhere. In some cases, the spread may be so tight that the risks are no longer properly reflected in the price.
The price of a bond can also be slow to react to recent changes to the risk/ reward balance - another potential reason to reassess.
In February 2018, spreads on bonds listed in the Bloomberg Barclays US High Yield Index reached lows, not seen in the last decade, a sign perhaps to check the relative value of your US high yield holdings. In October, spreads in that index again reached new lows of 303bps before gradually climbing up over last month to 409bps in November. The graph shows the average spread of high yield bonds in the index, adjusted for embedded options such as call opportunities that benefit the issuer.
Source: Bloomberg, FIIG Securities
Note: OAS = Option adjusted spread
3. Management fails to meet expectations
Management performance is really important in the assessment of any company and it’s even more important in high yield companies as they have less avenues of support if things go wrong. You need to feel like you can rely on management to make the best decisions. A lack of confidence should be like a red rag to a bull – SELL.
So, what are some of the signs to look for in management?
- Stability and low turnover of executives, length of time in positions
- Track record in this company and in previous companies especially in related industries
- Do they follow stated strategies, monitor their effectiveness and report on them?
- Filing accounts and other corporate obligations on time
- Number of legal actions against the company and potential damages – more for US based companies
Whilst we endeavour to keep you informed (through the WIRE and emails/ phone calls from your relationship manager) of significant changes to high yield company bonds, you need to do the homework and make the decision to buy, hold or sell on your own assumptions. Having a good understanding of your own tolerance for loss and search for yield will help you make rational decisions at the right time.