Bond villain: managing default risk in your portfolio

It will always be "junk" debt to some, but high-yield bonds have turned heads in the past year. Yields in the racier part of the fixed income universe moved into double digits amid the sell-off of early 2020, enticing bargain hunters and income investors.

Since then high yield bonds have posted strong returns, aided by monetary stimulus and cheap debt. Yet the party could soon end for some troubled bond issuers, with a wave of defaults potentially engulfing the market.

S&P Global Ratings analysts recently warned that increased debt could translate into higher insolvency risk, forecasting that defaults will “likely rise substantially, to levels not seen since 2009. Even though we expect very low funding costs through 2021, higher leverage and a large share of vulnerable corporates are likely to induce further defaults, resulting in the 12-month speculative grade default rate rising to around 9 per cent in the US and 8 per cent  in Europe by September 2021, versus 6.3 and 4.3 per cent [respectively] in September 2020,” they added, warning the sectors hit hardest by lockdowns – such as airlines, and oil and gas – could suffer most.

Similarly, Jim Cielinski, global head of fixed income at Janus Henderson, recently argued that defaults could peak in the first half of this year before falling back.

Any potential disruption follows a period of significant capital gains: in the US, the average yield on bonds included in the Bloomberg Barclays US Corporate High Yield index recently sunk below 4 per cent, a record low. Some funds have made huge gains: for example, Man GLG High Yield Opportunities (GB00BJK3W271), the strongest performer in the Investment Association (IA) Sterling High Yield sector in the year to 10 February, made a total return of 15.7 per cent.

Yet investors who jumped on the high yield bandwagon may want to reassess their exposures. Higher-yielding bond funds and certain cyclical companies could find themselves in trouble if the predictions prove correct.

When it comes to funds, it can help to look at where the higher yields are coming from. FE data indicates that 17 funds in the IA Sterling High Yield sector had stated historic yields north of 4 per cent, 10 of which are shown in the chart.

A high yield is not an unequivocal indicator of problems but does suggest that a level of risk is on the table, so digging into a fund’s underlying exposures is important. However, this is not always straightforward. For example, Schroder High Yield Opportunities (GB00B5143284) states a large exposure to industrials in its literature but there is little detail on what this entails. Other information is more reassuring: the fund has a low allocation to the US high yield market, an area associated with energy companies. And, like many bond portfolios, the fund is well diversified with 175 holdings at the end of 2020.

Others may seem more vulnerable, at least on the surface. Legal & General High Income (GB00B0CNHH27) has performed well but looks more exposed to vulnerable sectors. The fund had around 15 per cent of its assets in energy at the end of 2020, though again, diversification could help. The fund held debt from 360 different issuers at the end of last year.

This level of diversification, combined with small position sizes, means that generally a bond fund’s broader exposures are more important than individual bond holdings, from its sector and geographical preferences to the credit quality of debt that it buys.

The latter point is especially relevant for strategic bond funds, some of which seek better total returns by delving into high yield. They can also tend to focus on bonds with a BBB rating, the lowest rung of investment grade - higher rated debt considered less likely to default. BBBs can be vulnerable to downgrades to high-yield status, causing a knock to valuations.

The second chart shows how exposed some of the highest yielding strategic bond funds are to BBB debt and the high yield sector. Note that funds disclose their exposures differently and we have only included allocations that are obviously to parts of the high yield market. Even such disclosures can be a blunt tool: some funds may include government bonds in their credit quality rating breakdowns, for example. And not all funds make such disclosures.

The IA Sterling Corporate Bond sector should generally be less exposed to this trend due to its focus on investment grade bonds, though some of the funds have substantial exposure to BBB debt. Liontrust Monthly Income Bond (GB00B44MQ015), which has a historic distribution yield of 4.5 per cent, had a 66.7 per cent allocation to BBBs at the end of 2020.

It should be noted that for high yield and to a lesser extent BBBs, risk is part of the game and something that investors are often compensated for.

“High yield is [paying yields] of 3 per cent over government bonds – you are getting paid for defaults,” says Michael John Lytle, chief executive officer of fixed income ETF provider Tabula Investment Management. “There may be some defaults to weather but central banks are committed to supporting bond markets’ new issuance. The vast majority of companies will find ways to fund themselves and survive over next couple of years, so you continue to receive coupons.”

Some others are also more sanguine than S&P Global Ratings. TwentyFour Asset Management, a respected bond specialist, recently argued that the bond default peak may already be behind us. Globally they have witnessed more credit quality upgrades than downgrades in early 2021 – potentially setting the scene for further improvements. But even against this brighter backdrop they are seeing a good level of disparity between different sectors and regions.

As in the equity space, bullish investors may target racier parts of the bond market in the hopes of a recovery. This could be done via racier bond funds or more targeted plays. iShares Fallen Angels High Yield Corporate Bond UCITS ETF (RISE), for example, holds bonds that have been downgraded to high yield in the hope that they will soon return to an investment grade rating, providing a bump for valuations.

The corporate credit carnival

iShares Fallen Angels High Yield Corporate Bond UCITS ETF's holdings include $27m (£19.41m) worth of bonds issued by cruise operator Carnival (CCL) last April. Although this is the fund's largest holding, as it only accounts for 1.58 per cent of its assets, a default would not be a disaster for the fund's investors. Moreover, the inclusion is evidence of some of the handsome profits that risk-taking bond investors have made in a year of improbable credit market acquiescence.

When Carnival sold its $4bn bond, it did so in dire financial straits, with lock downs sweeping the globe and wall to wall coverage of port-less cruise liners. The price exacted from capital markets was steep: in addition to a convertible bond and a slug of equity, debt investors required that the bond in which iShares Fallen Angels High Yield Corporate Bond UCITS ETF had invested be secured against a fleet of ships and carry a coupon of 11.5 per cent.

Since April, memories of Carnival's ill-fated Diamond Princess cruise have faded to a small footnote, but the company's vessels have remained docked. And yet credit markets have, if anything, become more forgiving. Last week, Carnival sold $3.5bn of six-year unsecured bonds that pay an annual interest rate of 5.75 per cent.

According to S&P, the sale had been upsized by $1bn, illustrating the insatiable appetite for bonds in a company which many market commentators thought might collapse less than a year ago. Even as the latest bonds were being issued, ratings agency Moody’s flagged the possibility of credit downgrades, pointing to Carnival's need “to ramp up operations in a meaningful way in 2021” if the barest liquidity is to be maintained.

The 11.5 per cent bonds, which are due to be paid back in 2023 and carry no financial covenants, nudged up to a 15 per cent premium to par.

Anyone who thinks equities’ trade-offs between risk and price can’t get any dicier need only look to the corporate debt market. Nobel laureate Robert Shiller's cyclically-adjusted price-to-earnings indicator has shown that while equities are nearing dotcom bubble valuations, they are less overvalued when compared to bonds.

Infinite leverage cycles

If 2020 was the year of unending liquidity, there is so far little expectation that the dam might burst for corporates in 2021. The reason may be familiar to anyone who has followed the actions and steers of central banks of late.

“I’m quite comfortable in the near-term view that there will be enough near-term fiscal and monetary support to keep the ball rolling in terms of solvency and corporate credit quality,” said Peter Aspbury, head of J.P. Morgan Asset Management’s European high yield team, at a recent credit conference organised by Fitch Ratings.

Of course, this has also required debt investors to act on policy. And it is this dual faith in a fully underwritten market and hunger for yield which has pushed corporate bond markets into new territory. Even sector veterans sound dumbfounded.

Speaking at the same Fitch event, the agency’s global head of corporate ratings Richard Hunter noted that defaults have defied gravity in two important ways in the past year. “Even before the first lockdown happened, we had calculated around about $250bn of defaults that hadn’t happened in just the US bond and loan markets that you would have expected on our ratings,” he said. “Then you get into a pandemic, you switch the northern hemisphere on and off for three months, and the default rates we’ve seen have been very low.”

By “very low”, Hunter means default rates of between 4 and 6 per cent, which are “very low by historical standards for a peak in a recessionary or crisis era,” in both percentage and absolute terms.

Other records are falling. Just as ratings agencies try to keep tabs on companies’ debt to cash flow ratios – negative in the case of Carnival, save for fresh financing – bond maturities are moving further out. On one level, this is entirely rational: if markets are prepared to lend cheaply for years and years, then it is in the interests of companies to accept this cash.

By extending maturities, companies are also delaying near-term solvency issues or potentially tricky refinancing decisions. But the trend also leaves bond investors exposed should interest rates or inflation kick up in the coming decade. According to data and index provider ICE, the average investment-grade corporate bond duration is heading towards nine years.

If growing expectations of a higher inflation world start to materialise this could change everything. Though real yields in many sectors of the bond market are already negative, a major uptick in inflation would require investors to radically re-appraise the future value of the cash payments they had counted on. In many cases, this would be likely to result in forced selling, pushing up yields and the cost of debt capital for new issuers.

The fear – as always for highly-leveraged companies – is what higher inflation might do to interest rates. It’s worth stating that in the UK, the chief concern is whether bank rate will go negative in the coming months. Investors should also recall that recent history suggests that bond markets can function when inflation is running high.

For example, shortly after the Order Book for Retail Bonds was created in 2010, Lloyds Banking (LLOY) issued a 15-year 7.625 per cent coupon subordinated bond. At the time, interest rates were at 0.5 per cent, but UK inflation was tracking at just under 5 per cent. The former has since remained near zero and the latter has averaged 2.7 per cent a year meaning that, with the benefit of hindsight, the bond has been a solid investment.

Unsurprisingly, the bond trades at around a 25 per cent premium to par, leaving negligible returns until maturity for buyers. London Stock Exchange data also suggests that the bond’s time weighted bid-ask spread was 546 basis points in the week to 5 February. Heralded at its creation as a way for ordinary investors to easily trade bonds, illiquidity now appears to be one of Order Book for Retail Bond's main features.

But with leverage and inflationary fears rising this might not be bondholders' biggest worry in the coming years.