Tuesday 26 May 2015 by The WIRE investment news website Education (advanced)

Managing risk in your high yield bond portfolio

High yield bonds carry attractive yields but come with higher risk compared to investment grade bonds. As the risk profile increases diversity becomes of greater importance

High yield bonds carry attractive yields but come with higher risk given the risk/return relationship (compared to investment grade bonds). As the risk profile increases portfolio diversity becomes of greater importance and should be used to ensure that any loss of value for a particular bond is small in the context of the overall portfolio and offset by the high returns made on the remaining portfolio.

By way of background, high yield bonds are typically described as those which are unrated or have ‘non-investment grade’ credit ratings. This means that the highest rating a high yield bond can have is BB+ by Standard & Poor’s and Fitch Ratings, or Ba1 by Moody’s Investors Service.

So what are some of the key risks and considerations in high yield bond investment?

Credit Risk:  The largest concern with individual bonds is credit risk, or 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 cash flow and the survivability of the company, regardless of whether it’s shrinking or growing.

Liquidity: Another key risk is liquidity. Liquidity risk arises from situations in which 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 a drop of price to zero (where the market is saying that the asset is worthless). Instead, there are simply limited potential buyers in the market at that point in time. This is why liquidity risk is usually found to be higher in low volume markets and is exaggerated during times of high market stress, such as the GFC. Generally speaking, high yield bonds exhibit higher liquidity risks than investment grade bonds. A risk adverse investor would naturally want to be compensated for increased liquidity risk.

Volatility: High yield bonds typically display greater price volatility than higher rated debt securities.  Prices are more sensitive to the economic/corporate outlook and will typically underperform during a downturn and outperform during a recovery phase (compared to other fixed income classes).

Structuring and ranking in a liquidation process: Debt securities have an advantage over equity investments if a company goes into liquidation as 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 typically aimed at keeping as much cashflow as possible available to service the obligation. This may be achieved by limiting the amount of debt that can be attained and restricting payments out of the company such as dividends to shareholders.

Correlation: Another item to note in high yield bond investing is that their returns do not correlate exactly with either investment grade bonds or shares. Because their yields are higher than investment grade bonds, they are less vulnerable to interest rate shifts, especially at lower levels of credit quality. Because of 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 and as such it is suggested a good spread of industries be included in a balanced portfolio.

The bottom line:  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, high yield bond market where the various risks are higher, the importance of diversification is magnified. Failure to adequately diversify can significantly increase risk (correlation increases risk while diversification reduces it). Professional high yield fund managers will spread the risk across many bonds so that a potential value or liquidity issue or even default from a particular bond is small in the context of the overall investment portfolio. Moreover, any loss should be more than offset by the excess returns made on the remaining performing assets in the portfolio.

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Figure 1 gives an example of a balanced Australian Dollar fixed income portfolio.  The portfolio has about a 60% exposure to six investment grade bonds (about $100k each), and a smaller 40% allocation to a larger number (seven) and lower value (circa $50k) of high yield bonds. The portfolio is relatively conservative, yielding 5.46% to maturity, with a 5.50% running yield.

Figure 1: Example portfolio
Figure 1 example high yield portfolio
Yields on floating rate notes are estimated by the sum of the trading margin and the current swap rate to maturity; 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 (Figure 2). 

Figure 2: Portfolio diversification
High yield investment diversity graphs

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

The higher return from high yield bonds is compensation for typically increased credit and/or liquidity risk (compared to investment grade bonds). As the risk profile increases diversity becomes of greater importance and investors must consider this not just by asset type but also by industry sector, issuer, interest rate/payment type (fixed, floating or inflation linked), capital structure and various other measures.