Investors have got the wrong idea about high yield debt, according to Insight’s Robert Jones (pictured), who said the idea it means ‘bonds at high risk of default’ is a myth
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Jones, senior credit analyst at Insight, said two assumptions are generally made about companies whose debt is rated below BBB. First, they find it difficult to access funding as banks and corporates are unwilling to lend to them; and second, there is a much higher probability they will default.
However, the analyst said this ignores developments in capital markets over the past five to 10 years.
“The myths around high yield I think are totally wrong,” he explained. “A lot of companies there are happy with their leverage and capital structure and can run with that because they have a comfortability of their earnings and top line.
“Now you have BB and B credits that have good access to funding. And there are a lot of names that I’d much prefer to have as a double B rather than a single A given the risk/return that’s out there at the moment.”
Jones likes companies with stable earnings and "a runway of liquidity", that may have been given a low credit score due to the size of their debt. He said there are numerous reasons why they may have so much leverage, such as tax efficiency, or to increase return on equity, in the same way a home owner can use a mortgage to benefit from rising house prices.
Sources of liquidity
Source: Insight/BNY Mellon
“For example, if you buy a house for £100,000 and you put down a mortgage of £50,000 and equity of £50,000, if the house price doubles, your equity has gone from £50,000 to £150,000,” he explained.
“If you only put down £10,000 equity but have a £90,000 debt and the house price doubles, your equity has gone from £10,000 to £110,000.
“For those companies, the return on equity is attractive and for us as debt holders we’re happy to have that stability and to have that coupon through that cycle.”
The analyst pointed to Center Parcs as a typical holding in BNY Mellon Global Short Dated High Yield Bond, the fund he works on alongside managers Ulrich Gerhard and Cathy Braganza. He said the leisure company, which is owned by Canada’s Brookfield Property Partners, has debt of about six or seven times its earnings.
“But it generates cash flow,” he added. “This is a classic example of stability of the top line. In terms of the bookings it is always 96 to 98 per cent sold out because it tweaks its pricing strategy.
“A lot of the revenue drops down into its earnings and into its cash flow, which allows it to service their debt.
“In a [worst-case] Brexit scenario, it will benefit from staycations etc. So that’s the type of company that we would ultimately look for, with that stability of cash flow.”
Aside from looking for reliable cash flows, Jones aims to further reduce risk by focusing on companies further up the high yield band, avoiding bonds rated CCC or lower. He also invests in debt that is maturing in the next two to three years, saying this makes it less likely for a disruptor to emerge and threaten profits; he used the example of Blockbuster to show what can happen to a “steady” business over 10 years.
Performance of indices
Source: ICE BofA Merrill Lynch/Russell Investments
Even so, the asset class still comes with risks. With the current period of economic expansion in the US the longest on record, there are fears we could be due a recession and Jones said “if you feel it is 2008 all over again, high yield is not for you”.
However, he pointed out that even in the worst-case scenario, it will still do much better than equities.
“I’ve been in credit all my life and people always say I’m slightly boring just because I always look at the downside, and I could never invest in a six-bagger in terms of equity upside,” the analyst continued. “But likewise, I know my downside and my volatility are a lot lower.
“If things did go seriously wrong, equity is at the bottom part of the waterfall in terms of any repayments, whereas in bonds – although it depends on where you are on the capital structure – you’re the first to get paid.
“If people think this is a golden scenario and we’re having massive growth then I can see the benefits of equities. But to have a steady income with a lower volatility and something of a cap on the downside, that should fit into people’s portfolios.”
Performance of fund vs sector and index since launch
Source: FE Analytics
Data from FE Analytics shows that BNY Mellon Global Short Dated High Yield Bond has made 11.38 per cent since launch in November 2016 compared with 13.62 per cent from its IA Sterling High Yield sector and 7.72 per cent from its Libor +2% benchmark. The $700m fund is yielding 5.44 per cent and has an ongoing charges figure (OCF) of 0.61 per cent.