Head of European High Yield
High yield is a little bit different
The returns from high-yield bonds are positively correlated with those from investment-grade corporate bonds. No surprise there, one might think. But what is less well known is that the returns from high-yield bonds have a stronger correlation with equity returns. Over the 10 years to 31 March 2016, European high-yield bonds recorded a 55% correlation with investment-grade bonds, but a 73% correlation with European equities.*
Of course, past performance is no guide to the future. But historically, the correlation has been strong because the price of a high-yield bond has different drivers than a straightforward investment-grade bond. It’s not an equity – but at the same time, it’s not a conventional bond.
When you invest in equities, you receive dividend income, together with the potential for capital gains if earnings are on an upward trajectory. But equities can be volatile; because there’s no maturity date, they are characterised by almost infinite duration.
In contrast, with a high-yield bond, if you buy a five-year bond with a 5% coupon, you will collect the coupon (aka interest) each year.
Let’s illustrate the difference with imaginary company XYZ plc. Its expected sales growth is 10% per annum. Accordingly, its shares will be valued with a super multiple. But if those earnings expectations are revised downwards, the fall in the share price can be precipitous. As soon as a company goes ex-growth, its share price may fall dramatically, because as soon as a company loses its growth-stock ‘halo’, equity markets will punish it severely.
Contrast that with the experience of the investor in XYZ’s high-yield bonds. All things being equal, if the balance sheet still works when revenues are growing at 2%, high-yield investors don’t really care whether earnings growth is 5% or 10%. So long as the cash flows are sufficient to pay the coupon, bondholders care to a lesser extent whether the growth rate is slowing. That’s an equity story. The price of the bond might have been dented – but to nothing like the same extent as the company’s equity. As long as the balance sheet continues to work, by which we mean that the debt levels remain sustainable, high-yield investors are much more protected from the downside.
And don’t forget – coupons on bonds are contractual; a dividend is not. Instead, a dividend represents a promise – best endeavours. Additionally, bonds rank higher in a company’s capital structure than equities, which provides further relative downside protection in a worst-case scenario (default). Long-term average recovery rates for high-yield bonds are north of 30%. Equities, by definition, recover very little after restructuring or liquidation.
Focus on ‘not getting it wrong’
Investing in high-yield bonds, the emphasis is different. The focus is on the avoidance of downside risk. This is why at Aberdeen Asset Management, our credit process – our due diligence – is very in-depth. While we do a great deal of cash-flow modelling, the whole focus of our work is on the sustainability of the capital structure. And while it is important to understand the potential upside of any investment, it should be understood that the vast majority of return in high yield comes from the coupon. If you can avoid the ‘blow-ups’ – instances where companies lurch towards default – this will stand you in good stead.
Using our Total Analytical Package (TAP) system, we analyse a company’s balance sheet, its covenants, its net income statement, cash flows, liability structure and legal jurisdiction. We’re looking at all the things one would expect an equity analyst to look at, but our emphasis is different. We are less interested in the growth story and more interested in ensuring that we are being paid the appropriate level of income to offset the downside risks.
Take the customer base. It’s much better to invest in a business with 500 customers than in one with 20 customers. In the latter instance, the loss of a big contract could impair the company’s credit quality. But in the case of the larger company, a much more diverse revenue base represents more of a hedge against the loss of a few contracts.
We’ll also look at the company’s cost of goods sold. If there is exposure to raw materials, how does it hedge that? For example, its contracts might contain a pass-through clause, so that if there’s a spike in gas prices, the company can pass that on to its customers.
We’ll scrutinise the ongoing investment requirements of the business. While many analysts will focus on earnings before tax, depreciation and amortisation (EBITDA), we’ll look at this figure after capital expenditure.
The reason? A company can cut dividends. But what are the investment requirements of the business? If times become tough, can it afford to pare back capital expenditure? If so, it can continue to preserve cash flow and thus easily service the debt structure.
We look at the downside in every scenario: higher costs; lower revenues; lower cash flows. We look closely at covenants. If a company is going to trigger covenants, that could potentially signal default. We assess whether the company’s bankers are motivated to show forgiveness and forbearance in such a scenario.
The characteristics of high-yield bonds are more akin to those of equities than their investment grade counterparts. But for high-yield investors like us, the thrust of our analysis is quite different: rather than seeking out the next ‘growth’ story to profit from the potential upside, we seek primarily to avoid the ‘blow-ups’ and defaults that would threaten the return on our investment.
*Source: Merrill Lynch, iBoxx, JP Morgan, RIMES 31 March 2016. Correlation of monthly returns since 2006.
The value of investments, and the income from them, can go down as well as up and investors may get back less than the amount invested.
Past performance is not a guide to future results.