Tuesday 26 April 2016 by Education (advanced)

Managing risk in your high yield bond portfolio

High yield bonds play an important part in a portfolio, providing much needed higher income, particularly in a low interest rate environment. The most important way to hedge against those risks is to diversify. We explore key risks and other considerations as well as list some of the high yield bonds available


Unrated and sub investment grade bonds carry attractive yields but come with higher risk compared to investment grade bonds. As the risk profile increases portfolio diversity becomes more important. 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 there are now 24 bonds from 21 unrated, over the counter bond issuers with minimum parcels of $10,000.

By way of background, unrated and sub-investment grade bonds are typically referred to as high yield bonds which means they are not rated or hold a rating of BB+ or below by Standard & Poor’s or Fitch Ratings, or Ba1 or below by Moody’s Investors Service.

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 some 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.

Three key risks

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

The following chart illustrates the probability of default in a five year period by ratings band.

Standard & Poor’s five year probability of default by rating

Source: Standard & Poor's 2015 Annual Global Corporate Default Study, FIIG Securities

As you can see, the risk/return relationship is exponential, steepening as the rating falls below BBB- or into the sub investment grade area. 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

2. Liquidity risk 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 averse investor would naturally want to be compensated for increased liquidity risk.

3. Volatility High yield bonds typically display greater price volatility than those bonds with investment grade credit ratings.  High yield 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).

Other considerations

Structuring and ranking in liquidation

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, or restricting payments such as dividends to shareholders.


Another item to note in high yield bond investing is that bond returns do not correlate well with either investment grade bonds or shares. Because 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.

List of AUD high yield bonds

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, there are now 24 bonds from 21 unrated over the counter bond issuers available, and growing (and all with minimum parcels of $10,000). The following table details these bonds.

Issuer Bond type Maturity Yield Running Yield
360 Capital Investment Management Limited Fixed 19/09/2019 6.46% 6.81%
Adani Abbot Point Terminal Pty Ltd Fixed 29/05/2020 10.73% 7.18%
Adani Abbot Point Terminal Pty Ltd* Fixed 01/11/2018 9.40% 6.25%
Axsesstoday Group * Floating 09/10/2021 8.98% 8.77%
Capitol Health Limited * Fixed 12/05/2020 8.25% 8.25%
Cash Converters International Ltd Fixed 19/09/2018 7.76% 7.92%
CBL Corporation Limited Fixed 17/04/2019 6.01% 7.78%
CML Group Limited * Fixed 18/03/2022 7.58% 7.87%
CML Group Limited * Floating 18/05/2021 7.52% 7.41%
Dicker Data Limited Floating 26/03/2020 6.76% 6.68%
G8 Education Limited Fixed 07/08/2019 6.63% 7.43%
G8 Education Limited Floating 03/03/2018 6.38% 6.24%
IMF Bentham * Fixed 30/06/2020 7.19% 7.34%
Impact Group Aus Pty Ltd * Fixed 12/02/2021 8.34% 8.46%
Integrated Packaging Group Pty Ltd * Fixed 29/09/2019 7.06% 7.25%
Mackay Sugar Limited Fixed 05/04/2018 5.92% 7.08%
McPherson's Limited Fixed 31/03/2021 7.03% 7.08%
McPherson's Limited Floating 31/03/2019 6.62% 6.60%
Moneytech Finance Pty Ltd Floating 17/04/2022 6.88% 6.89%
NextDC Ltd Fixed 16/06/2019 6.08% 7.59%
Plenary Bond Finance Unit Trust Fixed 16/06/2021 5.85% 7.08%
PMP Finance Pty Limited * Fixed 17/09/2019 6.53% 6.45%
SCT Logistics * Fixed 24/06/2021 7.06% 7.46%
SCT Logistics * Floating 24/06/2019 6.57% 6.68%
Sunland Capital Pty Ltd * Fixed 25/11/2020 7.47% 7.53%
W A Stockwell * Fixed 29/06/2021 7.62% 7.72%

*Available to wholesale investors only

Example bond portfolio

The following table gives an example of a bond portfolio with a high yield component.  The portfolio has about a 75% exposure to eight investment grade bonds, and a smaller 15% allocation to five high yield bonds. The portfolio is relatively conservative with a yield to maturity of 5.58% and a 5.03% running yield.

Example bond portfolio
Security Security type Rating* Sector Portfolio weight Cost value Yield to maturity Running yield
Royal Women’s Hospital 30Jun33* Index Annuity Inv. Grade Infrastructure 17.9% $187,096 6.11% 4.30%
AGN-ILB-3.04%-20Aug25* Capital Indexed Inv. Grade Energy 13.1% $135,631 5.15% 2.95%
Sydney Airport 3.12%-20Nov30 Capital Indexed Inv. Grade Infrastructure 11.7% $122,363 5.99% 3.26%
Qantas-7.75%-19May22 Fixed Rate Inv. Grade Corporate 11.2% $118,999 4.76% 6.71%
Glencore-4.50%-19Sep19* Fixed Rate Inv. Grade Resources 9.2% $95,739 6.07% 4.72%
Sungrp-BBSW+2.05%-16Dec24* Floating Rate Inv. Grade Infrastructure 7.7% $80,424 4.76% 4.38%
PRAECO-7.132568%-28Jul20c Fixed Rate Inv. Grade Infrastructure 7.3% $75,740 4.98% 6.59%
JEM-6.637%-28Jun18c Fixed Rate Inv. Grade Infrastructure 7.1% $74,967 2.45% 6.33%
CBL-8.25%-17Apr19 Fixed Rate Non-IG Insurance 3.1% $31,874 6.01% 7.78%
Cash Converters 7.95%-19Sep18 Fixed Rate Non-IG Corporate 2.9% $30,379 7.76% 7.92%
SCT-BBSW+4.40%-24Jun19* Floating Rate Non-IG Corporate 2.9% $30,268 6.58% 6.68%
Dicker Data +4.40%-26Mar20 Floating Rate Non-IG Corporate 2.9% $30,225 6.77% 6.68%
G8 Education+3.90%-3Mar18 Floating Rate Non-IG Corporate 2.9% $30,136 6.39% 6.24%
$1,036,237 5.58% 5.03%

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.

will pie charts

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

Conclusion - 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 or high yield bond market where the various risks are higher, diversification is critical to spreading risk and protecting your portfolio. 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 of value should be more than offset by the excess returns made on the remaining performing assets in the portfolio over time.

Until recently the AUD high yield market simply did not have enough bonds to enable true diversification, but this has now changed and we encourage you to reassess your portfolio.