High Yield Bonds: Debunking The Myths

When a corporation needs to raise money in the bond market, the rating agencies will attach a "risk weighting" to that particular bond based on its research of the issuing companies ability to pay the interest due as well as the repayment of the full principle. 

According to the S&P scale (there is more than one rating agency, but I will follow the S&P scale for simplicity):

AAA is the highest rating and "the obligor's (issuer's) capacity to meet its financial commitment on the obligation is extremely strong".

Then there is AA (slightly more risk) and A ( even a bit more risk) and then BBB: which has "adequate protection parameters", but... "adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation".

All of the above are classified as "Investment Grade" bonds.

Below that, from BB through to C, levels of risk (of being able to meet financial commitments) do increase and as a result an issuing company must give better terms to the buyers, usually by raising the yield but also by adding security as well.

D is when a bond is in default.

The point is, that with increased risk, there is potentially a higher return that goes with it and that needs to be factored into the equation.

But what, historically is that risk? The term "junk" bonds has been used in the past, but what does that mean?

Let's look a little more closely:

The Capital Structure of a corporation (and who has priority to get paid in the event of a liquidation) looks like this:

High Yield bonds reside in the first two levels and have seniority to convertible debentures, preferred shares and common shares (which are at the bottom and from this perspective have greater risk).

Risk -Adjusted returns:

Over the last 5 years (to April 30) Canadian HY had better risk adjusted returns than the TSX or the Preffered Share Index.

This year alone, the year to date Total Return on The Advantaged Canadian High Yield bond fund (AHY.un ) on the S&P/TSX trading price is about 12.5% compared to the Preferred Share Index ETF (CPD) where it is -1.3%. 

Data is from Bloomberg, Total Return based on daily data from Dec 31, 2015 to July 19,2016. High Rock Capital Management is the manager of AHY. This is in no way a recommendation to purchase or sell any security, but only as an example of a basket of Canadian High Yield securities for illustration purposes. 

Obviously, we have a bias towards high yield at High Rock, because that is an area of our expertise. However, the evidence is clear: it is a good, non-correlated asset class that can add diversity and yield to a portfolio in a properly structured way (which should be discussed with your advisor to ensure suitability for you).

At High Rock we use some very specific and well-researched High Yield bonds to add value to our Fixed Income and Tactical models. Some have provided some very good risk-adjusted returns to our and our client's portfolios thus far this year.

Feedback, questions, concerns...

scott@highrockcapital.ca

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