Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 216

The dangers lurking for credit investors

After a few small wobbles earlier in the year, the chase for yield has resumed, pushing US equities to record peaks and taking credit indices close to their most expensive post-GFC levels. Fixed interest managers are reaching further along the credit rating menu in the search for higher returns. The credit market is sufficiently diverse to cater to different investor tastes in terms of risk and return, however, behind the lure of the high yield lies some not-so-hidden dangers which every investor should be wary of. We examine the case for spread decompression and the near-term catalysts that render high yield debt vulnerable.

High yield more vulnerable with falling inflation

One of these dangers is the evolving broader macroeconomic backdrop. For the first time in the post-GFC era, most of the world’s developed market central banks are on the path to policy normalisation. Critically, this is in the absence of a material pick-up in inflation and inflation expectations. In fact, both measures have actually fallen this calendar year as reflected in the chart below.

Inflation expectations have fallen recently

Source: Bloomberg

Historically, such declines in inflation expectations have been a negative for credit. Inflation expectations provide a gauge of sentiment towards future economic growth, which helps drive company revenues and debt servicing. It is important to make a distinction between debt in the investment grade camp (BBB or above) and junk bonds (BB or below), also known as high yield. It is the latter camp that is the most sensitive to a shift in the economic landscape. For example, the spread between the difference in yield on junk and investment grade typically widens when inflation expectations fall i.e. junk bonds underperform.

Contraction in high yield spreads versus inflation

Source: Bloomberg

Risks vary considerably within each credit rung of the junk bond category. While many credit investors turn to this area in an attempt to boost yields, there are varying degrees of risks that do not necessarily compensate the investor with a higher return. For example, in the CCC rating category, the extra yield declines considerably as debt increases. On average, a company with three times leverage only offers an extra 10 basis points above a company with two times leverage. Further, the ability of CCC issuers to service their debt would be severely impeded if rates rose just 1%, to the extent that the interest payments would need to be funded by issuing further debt.

Structural change leads to risks at sector level

There are also varying vulnerabilities at the sector level due to ongoing structural industry changes. These shifts cannot be weathered as easily by the high yield space when compared with their investment grade counterparts, given the former lacks the same financial flexibility.

Delving deeper, while the energy sector faces challenges from weaker oil prices, the telecommunications and consumer spaces look increasingly concerning as they endure significant drops in the price of their services. The Wireless Services Price Index has fallen 11% in the six months to the end of June 2017. While the reaction has been relatively muted in high yield credit so far, the negative impact has clearly hit share prices.

High yield telecommunications vulnerabilities increase as service prices plunge

Source: Bloomberg

The consumer-orientated areas are also a worry as supermarkets and food have joined the longer-term weakness in broader retail on the back of the Amazon-Wholefoods announcement.

High yield (junk) bonds to underperform

With these factors in mind, we believe the high yield credit area is much more vulnerable than its investment grade counterpart. Benefitting from the underperformance of junk bonds is achieved through buying protection on high yield indices and selling protection on safer investment grade credit. By selling protection on investment grade, the cost of our high yield trade is reduced. In turn, the trade performs well if we see a widening of high yield spreads versus investment grade. This is a relatively defensive approach that aims to protect portfolios, as well as offering a more active alternative that can still deliver returns when more conservative credit outperforms.

Within yield-focused funds, we advocate for a more diversified approach to generating regular income by looking beyond credit markets by exposure to Australian shares that are generating consistent dividends. The Australian share market has established a reliable track record of delivering dividend yields of around 4% since 1982 and presents a suitable complement to a portfolio of high grade credit and corporate debt. With this approach investors can mitigate the exposure to risks that are gathering steam in parts of the credit spectrum.

 

Amy Xie Patrick is Portfolio Manager, Income & Fixed Interest at BT Investment Management. This article is general information and does not consider the circumstances of any individual.

 

RELATED ARTICLES

BBB worries seen from beyond the headlines

Defaults low but no room for complacency

Why would you invest in junk?

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.