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

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 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. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.