Why are junk-rated bonds attractive?

For many retail investors, bonds are a conservative financial instrument with the potential to earn returns slightly above or at the level of a bank deposit. But this thesis applies only to “investment” bonds, but if you pay attention to “speculative” securities, then their nature is different – the profitability and risks are higher, but there are more opportunities for aggressive investors.

Risks and returns

“High-yield” corporate bonds are debt financial instruments that offer higher yields than other bonds. Classically, “high-yield” bonds are financial instruments with a  credit rating below “investment”, that is, BBB-/Baa3. These bonds are said to have a “speculative” or “junk” rating.

Nevertheless, the “rating” approach has one drawback: ratings do not always reflect the fundamental credit quality of the issuer at the current moment, and a significant shift both positively and negatively is possible. If we talk about the yield itself, then, according to analysts at SberCIB Investment Research, “highly profitable” are bonds traded with a yield of 4% or more in dollars with an average duration of 3-5 years.

Shown below are the average returns on the assets of U.S. Corporate High Yield Bond (HYG) and Investment Grade Bond (LQD) ETF* assets. It can be seen that dollar yields have declined significantly of late: BB-/B+ weighted average HYG is now trading at the same yield (about 4%) as A-/BBB+ rated LQD just a year and a half ago. In a world of low interest rates and high investor risk appetite, high-yield bonds are becoming an increasingly important asset class, but at the same time require a more careful choice of financial instruments for building an investment portfolio.

Yields on US Corporate High Yield Bond (HYG) and Investment Grade Bond (LQD) ETF assets

The possibility of obtaining increased profitability is a consequence of increased risk, in this case, credit. If we look at the market average default probability for each rating category, we will see that it rises quite sharply when moving into the “junk” category and quickly grows further when the rating deteriorates.

Probability of issuer default within 20 years depending on the rating

Sources of increased credit risk can be various factors, such as the immediate financial condition of the issuing company, the external realities of the industry or national economy, the position of debt in the capital structure of the issuing company and specific terms of issuance, as well as “soft” factors – the profile of business owners, political aspects etc.

Features of “high-yield” bonds

In fact, apart from simply increased risk offset by possible additional returns, such financial instruments are quite different from “investment” grade bonds.

High-yield bonds are becoming less sensitive to changes in interest rates as yields rise: rather, corporate profits and cash flows (both at macro and micro levels) and the general state of the economy become the key driver. In this regard, “high-yield” bonds are even placed closer to stocks than to less risky financial instruments, which also translates into increased price volatility.

In the world of “high-yield” bonds, there are extreme segments – stressed and distressed debt, that is, the debt of a business that is in a difficult situation with an increasing chance of restructuring or default, and the debt of an issuing company that is already inevitably approaching this development or has gone through it. Such bonds trade well below par, implying a current equity value of zero; often, in the course of restructuring, current creditors also become shareholders of the issuing company. Bonds of this class become even more volatile and, in this sense, even closer to stocks in nature. Below is a chart of the change in the price of Eurobonds of the Argentinean oil and gas company CGC (due in November 2021), which can be classified as stressed in terms of their level of profitability and price. For securities of this issue, movements of ±20% over several months are quite common.

Change in the price of Eurobonds of the Argentinean oil and gas company CGC (%)

This nature of “high-yield” bonds rightfully gives grounds to consider them a separate asset class with its own risk / return characteristics, relatively low correlation with the “investment” bonds segment and interest rates, and, accordingly, their place in the investment portfolio. In addition, a stock can be fundamentally undervalued for a very long time, while a bond involves a coupon payment and its redemption / redemption (in the absence of a default, of course).

This asset class is very interesting in terms of the potential for higher risk-adjusted returns. Factors such as a recent restructuring or problems in the major shareholder’s side businesses have a strong influence on the level of potential profitability. Often, the fundamental credit quality of the issuer itself does not suffer from such factors, and the conditions and structure of the issue of securities provide protection to creditors.

Examples

A striking example is the Eurobonds of the Ukrainian company Interpipe, issued in 2019 as part of a long and painful restructuring for creditors, which was reflected in the yield at the placement stage of these securities in the amount of 10.25% (in dollars). In fact, as a result of the restructuring, the business of the issuing company turned out to be in very good shape and generated large cash flows with a debt load of less than 0.5x (net debt / EBITDA); the bonds were redeemed ahead of schedule at the end of 2020 – beginning of 2021 with liquidity from the issuer’s balance sheet (the company’s new issue is currently in circulation with a yield of about 8%).

Another good example would be the bonds of drilling company KCA Deutag, also issued as part of the restructuring, with a yield of 9.875% (in dollars), which, according to SberCIB Investment Research, did not at all reflect the issuer’s much stronger credit quality. Expectedly, the yield on the issuance of these securities fell to about 5.5% in less than half a year. In addition, many market segments are still poorly covered by analysts and therefore asset pricing can create attractive opportunities.

Despite all the advantages, “high-yield” bonds are a very high-risk asset class. The usual logic “bonds always have less risk than stocks” may stop working – stocks of a large and stable business will be more reliable than bonds of an issuer approaching financial “stress”. The credit analysis of “high-yield” bonds is quite multifaceted and takes into account not only the financial and operating profile of the issuing company, its position in the industry and stage of the life cycle, but also the legal aspects of issuing its securities, the capital structure and the possibility of abuse by management and owners.

Managing a portfolio of high-yield bonds used to require a thorough approach and, as a rule, was in the hands of professionals. To access the Eurobond market, there were high entry requirements – from $ 200,000, transactions were carried out only OTC **. However, Sberbank has created a new unique product, and now investors have the opportunity to purchase Eurobonds with a potential minimum ticket of $1,000. Today in  SberInvestor You can make online transactions with Eurobonds with a wide list of issuers and instant execution of orders up to $1 million. That is, in fact, the investor, depending on his status as qualified or unqualified, already now has the opportunity to select and purchase more than 120 Eurobonds for compiling currency portfolios. At the same time, the list is constantly updated.

Today, the product is available not only to retail investors in SberInvestor, but we also offer it to financial institutions – brokerage, management companies – and are working to bring it to more electronic channels.

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