Junk bonds: what's in a name?
Simon Doyle, Head of Multi-Asset & Fixed Income, explains that in a world where yield is scarce and risk mispriced, we believe sub investment grade credit is a neat half-way-house that investors should consider as part of a well-diversified, globally oriented portfolio.
Sometimes names can tell you all you need to know, but sometimes they can be misleading. Take global high yield debt – a.k.a. “junk bonds” or “sub-investment grade debt” – often maligned as being risky and often avoided in investor portfolios for this reason. Risk though is relative and while they clearly carry more risk than their investment grade counterparts, they can and do play an important role in generating returns for investors and typically with less risk than often assumed.
There is no free lunch in investing. To access high yields investors need to assume some risk. One way to do this is to step down the capital structure, taking exposure to “subordinated” or lower ranking debt issues, often by good quality, investment grade issuers (like Australian bank hybrids). The higher yield comes because in the event of the issuer defaulting on its obligations, the investor sits behind more senior and secured lenders for access to residual assets (but still ahead of equity shareholders)
Another way is to invest in the debt of lower rated borrowers. These can be, and often are good businesses, but may be more highly leveraged or operate in highly cyclical industries with less reliable cash flows. As compensation for these additional risks, investors are paid higher yields. For the most part these borrowers are rated by the major rating agencies and can range in quality from “cross-over” credits – securities that sit just outside the investment grade space through to securities that are very low quality and borderline “distressed” credits. Because of this significant divergence in quality, the compensation investors receive will also vary enormously across this spectrum.
For Australian investors it needs to be recognised that we do not have a well-developed “sub-investment grade” bond market – in fact there are only a handful of sub-investment grade bonds on issue, along with a small number of “Non-Rated” issuers that in our opinion would fit this category. Examples include G8 Education, PaperlinX, PMP Limited and Cash Converters. The lack of a well-developed sub-investment grade bond market is in a large part because of the broader quality of the companies active in debt capital markets in Australia but also because of the role banks and equity markets play in this market in funding lower quality businesses.
As a consequence, investors who want access to Australian “higher yield” can do so by stepping down the capital structure (hence the attraction of securities such as bank hybrids). However, these securities are concentrated in a small number of issuers (dominated by the local banks), carry inherent structural risks and are often mispriced as they typically over-owed by individual investors.
With this in mind, accessing global sub investment grade securities provides investors with an alternate source of high yielding securities in a different way to that which can be accessed via domestic securities only. Chart 1 below shows the estimated AUD Hedged Yield for US High Yield along with the Bloomberg Bank Bill Index yield by way of reference. It is important to note here that global sub-investment grade debt should not be seen a defensive asset (nor should hybrids for that matter), but as a high yielding, low risk proxy for growth and/or alternative assets. In this context it does demonstrate greater volatility than more defensive fixed income options and will typically see prices fall in “risk-off” environments, but it is significantly less volatile and will typically fall far less than equities during these periods.
Source: Merrill Lynch, Bloomberg, Schroders.
(Note: The Merrill Lynch US High Yield Index AUD Hedged Yield includes an estimate of the additional yield derived by hedging to AUD based on interest rate differentials and using foreign exchange forward contracts.)
While it is easy to make investment arguments on the basis of diversification, diversification of losses makes little intuitive sense, so similar to any other asset, investors need to ensure the price paid makes sense. This is especially true in debt markets, as unlike equity, the upside to returns is capped to the payment of coupons and the return of principal (provided the securities are held to maturity). Valuations need to ensure that investors are being compensated for the inevitability that some issuers within the high yield portfolio will default (adjusted to the extent that the sale of assets will result in some recovery value), together with compensation for the additional volatility associated with this market.
For many the GFC was an awakening to the risks inherent in credit. While this was a scary experience for many it also created a “once in a lifetime” opportunity to invest in credit across the risk curve. Today, the opportunity is less stark – spreads are lower and the credit cycle both anaemic and extended. However, in a world where yield is scarce and risk mispriced, we believe sub investment grade credit is a neat half-way-house that investors should consider as part of a well-diversified, globally oriented portfolio.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.