Over the last few weeks, we have brought several new US dollar denominated high yield bonds to the DirectBond platform. With Australian dollar bonds being relatively hard to source at the moment, the US dollar space has been providing an interesting and attractive source of alternative investment opportunities
However, investing in offshore securities can often feel more uncertain and risky than the domestic market. In this article, we highlight some of the relative advantages of US high yield opportunities, as well as some additional risks that investors should take into consideration.
Reasons to invest
1. Choice
The US corporate bond market is the most mature and developed credit market in the world. According to data published by the Securities Industry and financial Markets Association (SIFMA), the total volume of US corporate bonds outstanding as at 3Q16 stood at around USD8.5trn, of which approximately USD1.4trn is high yield debt. With hundreds of corporate issuers across a broad spectrum of industry sectors, investors are able to choose from a wide range of investment opportunities in the US high yield corporate bond market.
2. Liquidity
Many of the US high yield bonds outstanding will benefit from a relatively large issue size (e.g. USD500m or more), which implies potentially greater trading liquidity for investors versus Australian dollar bonds. In addition, there is a wide range of global investors who participate in the US high yield bond market, ranging from mutual funds and pension funds to hedge funds and specialty investors. This can often result in opposing investor views that lead to greater trading volumes on certain bonds, thereby further improving market liquidity.
3. Not all high yield debt is equal
Corporate debt can be high yielding for a number of reasons, and not all high yield bonds carry the same type of risk.
Some high yield bonds may have been investment grade rated previously, but perhaps due to operational deterioration or debt funded merger and acquisitions transactions, are now rated sub investment grade. These types of bonds are referred to as “fallen angels”, and in some cases, the sub investment grade rating may be short lived. Some corporate issuers lack the scale or operating track record to warrant an investment grade rating to begin with, but over time, may prove themselves to be increasingly credit worthy.
High yield bonds just below investment grade ratings perceived to be improving in credit quality are referred to as “rising stars”. Depending on the prevailing circumstances, an investor may be better off buying a sub investment grade rated “rising star” than an investment grade rated falling angel. Also, high yield bonds of similar ratings may be trading at prices that correspond to very different yields, often driven by industry, sector and regional trends, as well as the fundamental quality trajectory of the credits.
4. Public equity and information flow
Many US high yield corporate issuers have publicly listed and traded equity. Such listings mean that it is mandatory for quarterly accounts and any material events to be filed with the SEC, which is also publically accessible. The majority of these companies publish results and announcements on their investor relations website, and investors are able to subscribe to email alerts relating to news and announcements. Such mandatory filings and announcements mean that investors are better informed on developments which may affect the credit quality of these corporate issuers versus privately owned companies.
5. Not limited to US exposure
Many large cap high yield companies in the US may operate globally, and thus provide investors with the ability participate in non US centric trends. However, investors ought to be aware of the added complexity of embedded foreign currency risk when making such investment decisions. (See more below on currency risk.)
Risks to consider
1. Currency risk
For investors whose base currency is Australian dollars, investments into offshore non AUD denominated securities necessarily mean the addition of foreign currency risk in their portfolios.
This risk should not be underplayed.
Absent of extreme moves caused my market stress and large idiosyncratic credit moves, foreign currency movements are likely to be the largest contributors to the performance volatility of a non AUD portfolio. By way of illustration, in the last twelve months AUD versus USD has seen a high of 0.7813 and a low of 0.7039 – close to a 10% move from high to low. Indeed, over the last five years, annualised 100-day moving average historical volatility on AUD/USD has averaged around 10%. The same 100-day moving average historical volatility for the Barclays US High Yield total return index is around 3.5%.
2. Duration risk
The more seasoned US high yield corporate issuers will tend to have a well populated debt maturity curve, which provides investors with some choice as to how much duration risk they want to take in their investment decision.
The capital price of longer dated bonds will typically be more sensitive to changes in interest rates than shorter dated bonds. Changes in credit spreads (resulting from changes in the markets’ assessment of the underlying credit quality of issuers) will also typically exert a greater capital price impact on longer dated bonds versus shorter dated bonds.
3. Capital price matters
In the majority of cases, US high yield bonds are fixed rate bonds that pay semi-annual coupons and return 100% of the original face value at maturity. However, the capital price at the time an investor enters into a high yield bond can alter the asymmetry of risk-reward. For example, a bond issued at a capital price of 100% may be trading at 80% a few months later, driven by any number of factors. If investors believe those negative factors are temporary or can be overcome, and their convictions are proven to be true, they will have only paid 80% for an investment that will pay them coupons and return 100% of the original face value at maturity. If they are proven to be wrong and an event of default occurs, the lower cash price paid for entering the investment will have cushioned some of the downside, depending on what the ultimate recovery value of the investment is in that scenario.
Investors should be mindful when investing in bonds trading at a significant capital price premium relative to par.
4. Structural and contractual subordination
A corporate issuer will often have different “layers” of debt in its capital structure. These layers refer to the relative seniority or subordination between different bonds, and this difference affects the investor’s expected recovery rate in the event of a corporate default. For example, senior secured bonds from a corporate issuer will have explicit recourse to a defined pool of assets in the event of default and would therefore rank ahead of senior unsecured bonds.
Although there can be large differences in the yield offered between the different levels of bonds of the same issuer, there may also be significant differences in recovery expectations in the event of a default. Investors need to be aware of where their investment ranks in the capital structure, and what that may mean for expected recoveries.
5. Restrictive covenants
Covenants are the terms and conditions that a corporate issuer needs to adhere to, and often place restrictions on what the issuer can do in order to protect the interests of bondholders. Investors need to be aware that covenants differ between high yield bond issues, even issued by the same company. A very high yield may reflect a poor set of covenants and a lack of protection.
For example, a common covenant is debt incurrence which may state that if financial leverage (broadly defined as debt to earnings) exceeds a certain level, the issuer is prohibited from incurring more debt. This protects existing bondholders by preventing their asset recovery pool from being further diluted by more creditors, or from their current position in the capital structure being layered by new and more senior debt. However, such restrictive covenants are not always present and each high yield bond may differ in its covenant package.