Bond platforms are currently advertising double-digit returns of up to 14 per cent on high-yield bonds. The headline yield can tempt investors, but they need to understand the credit and liquidity risks in these instruments before committing their money.
What counts as high yield?
There is no regulator-provided definition of high-yield bonds. “Bonds offering double-digit yields, particularly above 11 per cent, are generally considered part of the high-yield segment. They typically fall in the AA- to BBB rating range,” says Ankit Gupta, founder director, BondsIndia.
“High-yield bonds form a very small portion of the overall corporate bond market,” says Vishal Goenka, co-founder, Indiabonds.com. Retail participation in these bonds, however, is growing. “More than 50 per cent of bonds bought by retail investors on our platform are high-yield,” says Goenka.
Why investors go for them
Their primary draw is the high returns they offer. “They can offer significantly higher yields than traditional fixed-income avenues such as fixed deposits and AAA-rated bonds,” says Gupta.
Many issuers are younger companies that cannot currently command the same credit ratings as established peers in their sector. “Some higher-yield issuers may be in a strong growth phase and expanding faster than their industries,” says Gupta.
A carefully selected and well-diversified high-yield bond portfolio can raise the return potential of the fixed-income allocation. “They can complement AAA-rated bonds and other low-risk fixed-income instruments,” says Gupta.
Demand enough extra yield
Investors should insist on adequate compensation for moving down the credit-quality ladder. Lower-rated corporate bonds typically have maturities of around one to three years. “A yield spread of around 400 basis points, or 4 percentage points, over equivalent government bonds can make lower-rated corporate bonds worth considering,” says Goenka. He cautions that retail investors should avoid the riskiest corporate bonds rated BBB or BBB-.
Default is the key risk
A bond offering 12-14 per cent instead of around 8 per cent indicates that the issuer cannot raise money at the lower rate. “The fact that an issuer has to pay a higher yield signals greater perceived risk,” says Joydeep Sen, corporate trainer and author.
Default can occur on a scheduled coupon payment or when the principal falls due for repayment. “The probability of default can rise substantially for lower-rated bonds,” says Vishal Dhawan, chief executive officer (CEO) and founder, Plan Ahead Wealth Advisors.
Business conditions affect an issuer’s ability to service debt. “Business risks become more pronounced during a cyclical slowdown or during a recessionary or weak economic environment,” says Dhawan.
If a high-yield bond suffers a credit rating downgrade, the downgrade can hurt its market value. “After a downgrade, the bond’s current value may be lower than the purchase price paid by the investor,” says Dhawan.
Assess liquidity risk
Government securities and AAA-rated corporate bonds have relatively good liquidity. Liquidity becomes more problematic in lower-rated bonds. “These bonds can usually be sold, but the investor may have to accept an unfavourable price,” says Sen.
Dhawan warns that a downgrade can make an exit more difficult by reducing liquidity further.
Hold until maturity if possible
Investors can reduce some of the liquidity risk by matching their holding period with the bond’s maturity. “Holding the bond until maturity can avoid this selling-related liquidity risk,” says Sen.
Mark-to-market fluctuations also affect a bond’s price. When market yields rise, bond prices can fall. “Matching the investment horizon with maturity reduces exposure to mark-to-market as well,” says Sen.
A laddering strategy, in which investors hold bonds with different maturities, can also help. “A laddered portfolio can help investors match different investments with different horizons,” says Sen.
Diversify widely
Diversification is crucial in a high-yield portfolio. “It can reduce the impact of one issuer defaulting,” says Dhawan. Investors need a substantially larger investment corpus to diversify adequately.
“A high-yield bond portfolio should ideally contain around 20-25 bonds diversified across five to seven sectors,” says Dhawan.
Who should invest?
Only investors who understand credit risk should invest in high-yield bonds. They should know what security or collateral backs the bond. “They should be able to assess how the issuer’s balance sheet supports its debt,” says Dhawan. Investors with a higher risk appetite may consider these bonds. Retirees who cannot tolerate loss of principal, conservative investors, and investors for whom capital preservation is paramount should avoid them.
Investors who already have substantial equity exposure may also have less need to add high-yield credit risk to their fixed-income allocation. “An investor with 60 per cent equity already has substantial exposure to a high-risk, high-return asset class. Such an investor need not necessarily take additional credit risk within fixed income,” says Sen.
Cap exposure
Allocation to high-yield bonds should reflect the investor’s risk tolerance. Around 15-20 per cent of the fixed-income allocation should suffice.
Investors should also cap exposure to each issuer. “Exposure limits should become tighter as the credit quality of the issuer declines,” says Sen.
Dhawan adds that in a high-yield portfolio containing about 20 bonds, exposure to one issuer should not exceed around 5 per cent.
Prefer managed routes
For most retail investors, a professionally managed route may be more practical than buying high-yield bonds directly. “Many retail investors may not have enough capital to create a sufficiently diversified direct bond portfolio,” says Dhawan.
Direct investors may also struggle to sell their bonds in the secondary market when they need money, whereas mutual fund holdings can be redeemed at the net asset value. “Retail investors may also have limited ability to analyse a company’s balance sheet or assess the security or collateral available against a bond,” says Dhawan.
A credit risk fund provides professional credit assessment and better diversification than most retail investors can achieve on their own. “Their returns may appear lower than those available from individual high-yield bonds because these funds hold some higher-rated securities to meet redemption requirements.”
