High Yield Opportunities: Good Bonds in Bad Businesses?
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Article Type
Insights
Topic
High Yield
Published
November 06, 2024
Read time
5 mins
Authors
Thomas Hanson, CFA
Mark Benbow
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Investors often compare bond and equity markets. While there are similarities, the investment approach differs. Bond investors are typically walking along the pavement trying to not step on the cracks as they mitigate downside risk, whilst equity investors are often looking up at the stars trying to uncover high growth companies.

 

Although markets are asymmetric and bonds face greater downside risk with relatively limited upside compared to equities, this doesn’t mean that bond markets don’t offer compelling upside potential. Managers can turn this asymmetry on its head, by uncovering bonds that should offer downside protection while also providing upside return potential. To find these opportunities, managers and investors often look for ‘good’ bonds in ‘bad’ businesses. What exactly does this mean, and why do they invest in ‘bad’ businesses? Let us explain…

 

Uncovering good bonds in challenged businesses


Relative to equity investors, bond investors typically aren’t as fixated on identifying companies with high growth rates that provide the most attractive investment ideas. Rather, in the bond market, companies facing challenges tend to have the most mispriced securities, presenting cheap buying opportunities that can offer some upside potential. While lower priced bonds may offer significant price appreciation potential as the bond prices pull to par over time, there is also downside risk, especially for the more challenged companies. As a result, it is essential to balance risk and returns and conduct rigorous bottom-up research.

 

An important consideration in the bottom-up security selection process is capital structure positioning. Bonds higher in the capital structure can offer more protection and higher priority on claims while subordinated debt can be exposed to more downside risk or capital loss in the event of a corporate default. Given the level of risk differs across the capital structure, the yields and return potential also vary across the capital structure, which can present compelling arbitrage opportunities to identify good bonds in challenged businesses, while selecting bonds that offer more potential capital protection.

 

For example, let’s consider the following investment examples:


US telecommunications company
While the business is facing challenges, the recently issued secured bonds offer low leverage. The bond indentures also restrict the issuer from issuing bonds that would be on par or more senior to the existing bonds, which ensures that the existing bondholders’ repayment priority isn’t diluted. The bond pays double digit coupons and even if this business were to file for bankruptcy, it is likely that the bonds could offer a full recovery.

European real estate company
The company is facing pressure to lower its debt burden and cost of financing. Its newly issued secured bonds pay an attractive double-digit coupon. Like the above example, this is a relatively low risk bond in an otherwise overindebted company.

 


European telecom business
This company is at risk of having value leakage to support the debt burden in their French unit. While the structure has traded down in price, there is a bond where the proceeds for repayment sit in an escrow account which makes it a bankruptcy remote instrument, should the worst happen. Again, a relatively low risk way to access an otherwise risky business.

 

 

The key question for bond investors


At the heart of high yield investing is one key question – will investors get their money back? If the answer is yes, then the investor could be agnostic to the performance of an underlying business. If there is the potential for 100% recovery in both strong earnings environments and in a worst case default environment, then ultimately that is all that matters – protecting capital whilst earning high rates of interest.


Like any asset class, the high yield market is comprised of growing, stable, as well as declining, companies. There are many companies within the high yield market that are experiencing rapid growth and improving fundamentals. However, just because a company is performing well doesn’t make it a good bond investment. This bond may be duration sensitive and trade down amongst higher all in yields.


Take Google as a classic example: Investors who bought the equity in 2020 were positioned to make an almost 200% return. Those who bought the 2060 bonds, they stood to lose almost 40%. The inverse is also true for equities which have struggled while the bonds have performed very well – Credit Suisse a prime example. Those who bought the equity may have lost almost all their capital. But, the senior bonds were one of the best performing bonds in European high yield in 2023 with total returns of over 20%. These examples illustrate that bond investing is very different to equity investing and that is why, as high yield investors, the bond is often more important than the business itself.


Just because a company is struggling now doesn’t mean that the bonds don’t offer good relative value. Many times, the bonds from the more challenged companies can offer the most attractive upside potential or full recoveries under most scenarios. These situations can present intriguing opportunities to uncover ‘good’ bonds in ‘bad’ businesses and enhance an investor's potential total return.

 

For illustrative purposes only. All investments contain risk and may lose value. Investing in the bond market is subject to risks including market, interest rate, issuer, credit, inflation and liquidity risk.

Disclosures

Authors

Thomas Hanson, CFA
Portfolio Manager
Thomas Hanson, CFA, portfolio manager, specialises in high yield bonds and is responsible for co-managing our global high yield strategies.
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Mark Benbow
Portfolio Manager
Mark Benbow, portfolio manager, specialises in high yield bonds and is responsible for co-managing our global high yield strategies.
View profile
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