June 2016
AFR Global tactics
Junk bonds: What’s in a name?
Simon Doyle, Head of Multi-Asset & Fixed Income
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.
Schroder Investment Management Australia Limited ABN 22 000 443 274
Australian Financial Services Licence 226473
Level 20 Angel Place, 123 Pitt Street, Sydney NSW 2000
AFR Global tactics: June 2016
Merrill Lynch US High Yieled Index AUD Hedged Yield and
Blolomberg Bank Bill Index Yield
25.0
20.0
15.0
10.0
5.0
0.0
Merrill Lynch US High Yield AUD Hedged Yield
Bloomberg Bank Bank Bill Index Yield
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-wayhouse that investors should consider as part of a well-diversified, globally oriented portfolio.
Important Information:
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
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