The pros and cons of high yield bonds

One of the unlikely outcomes from what we now might call the “franking credits scare” that dominated the election campaign has been the realisation among many investors that they need to look further for income.

Many investors have yet to fully explore bonds, especially high-yield bonds. A high-yield bond is one that has a sub-investment grade or no credit rating. For those bond issues that are rated, the lower the credit rating, the higher the risk and the more investors expect to get paid.

What are benefits of high-yield bonds?

1. The return, anywhere from 5 per cent into double-digit returns for very high-risk bonds.

2. The US market is large and deep, with some well-known international companies such as Hertz and Avon.

3. A growing domestic market with mid-sized companies now issue bonds. Mostly, these are through specialised dealers in the over-the-counter market, few are listed on the ASX.

4. Bonds are tradeable and there is a potential for higher-than-expected returns. For example, a few years ago US dollar Fortescue Metals bonds were trading at substantial discounts — around $US70 with $US100 face value, payable at maturity if the company continued to operate. Investors who had faith in the long-term survivability of the company and bought at the low point made substantial equity-like returns as performance improved and bond prices increased.

5. Bonds can be issued with clauses (known as covenants) restricting extra debt or maintaining certain minimum requirements, providing comfort to investors.

What are the risks?

1. Default risk is the most significant. Do your homework and understand the limitations of the company and what it has in its ­arsenal to get it out of trouble — for example, unencumbered ­assets, wealthy shareholders, access to debt markets.

Default doesn’t mean loss. It means the company issuing the bond fails to make an interest or principal payment on time. In some cases, payment is made in a few days. According to S&P Global, the historical default rate on high-yield bonds is 4.5 per cent a year and the average recovery rate is 45 per cent of face value.

2. High-yield bonds act a lot like the underlying shares. So investors need to be prepared to accept equity-like volatility. But remember, bondholders are paid before shareholders in a wind-up and this is one of the reasons bonds are lower risk than shares in the same company.

3. Illiquidity risk is very important. No one will be buying these assets in a GFC-type situation. Investors will head for the exit at the same time, so you would expect bond prices to plummet.

4. Every high-yield bond is different, even if issued by the same company. If you want to invest in individual bonds, get hold of specific debt-related research and understand the risks and covenants in the documentation.

As published in The Australian on 21 May 2019