Things we don’t like and know to be worthless we discard. We call it trash, throw it away and will even have to pay for its disposal, one way or the other. What we call junk has no value for us anymore, but we still know that there is some residual value, if a little. We take it to the junk yard, to a junk market or put it in a junk box for future consideration.
When investors talk about junk or ‘high-yield bonds’, they mean fixed-interest bearing obligations where the borrower is known to have considerable difficulties to repay their debt or not sufficient assets to fully cover it.
It may well be that the company or the municipality as the principal was in good standing when such bonds were initially issued but has fallen on hard times and is therefore struggling to create enough revenue to safely service all outstanding debt. But in many cases debt is issued or traded with market participants being fully aware of the considerable risks involved. These brave investors are typically rewarded with substantially higher yields or interest payments.
Not all junk is equal, though. Like the guy in a scrap yard, experts grade junk bonds from still quite valuable to almost worthless, from not-investment grade to being in full default already. Grades given by credit rating agencies like Moody’s or Standard & Poor’s function as broadly accepted risk assessment, their plunders in the financial crisis notwithstanding.
A special case is high-yield bonds which are issued with the expressed aim of swallowing losses in the first place and to prevent equity damage to the principal. These are the so-called ‘Coco bonds’ or AT1, issued by banks to beef up their capital cover in a crisis. The borrower may have a good credit rating, but such bonds are still high-risk – yet another variety of junk and one badly understood, for that matter.
To invest in such instruments, regardless of its heightened risks, is not a gamble. Risk and reward should have mathematically the same relationship as any ‘safe’ investment. Astute traders can turn the most hopeless bankruptcy into a profitable business and retail investors buying into a high-yield fund can take some comfort from the fact that taken together the default rate of junk borrowers is considerably lower than the bad debt most banks have accumulated over the last 10 years. Moody’s predicts the overall default rate not to exceed three per cent in 2018. Deducting such losses from an assumed eight per cent yield would still be a satisfactory return, wouldn’t it?
Alas, such alluring returns have all but disappeared. Investors in desperate search for positive yield have piled into this niche market and driven prices to such levels as if default and bankruptcy could never happen again in our lifetime. Struggling telecom firms, over-indebted broadcasters and cable and satellite companies, shale gas drillers deep in the red… they all started to look respectable and bankable if they’d returned just a trifle bit more than zero on their 10-year bonds.
Such are the negative effects of ‘quantitative easing’, the willingness of central banks to buy up the world’s investment-grade debts in such vast quantities means there is not much left for us to invest in. There is not much left even for them to buy anymore. And as this central bank buying spree has driven up prices to vertiginous heights, yields have all but dried up. As a result, 11 trillion bonds have a negative yield today, signifying a guaranteed, accepted loss for those prudent enough to consider safety.
At this time, when all asset classes are priced to perfection, any unexpected event can rock the markets
Last month the Swedish bank Nordea issued an AT1 bond (see above), promising 3.5 per cent interest payment for an instrument which can extend repayment indefinitely and can be recalled opportunistically when prices are depressed – features which would warrant much higher yields. Buyers queued to the tune of €5 billion to fetch at least a small share of a bond totalling a mere €750 million. Yearning for yield, they were willing to put their money at peril when things turn sour, as happened with Banco Popular earlier this year.
Popular’s ‘contingent convertibles’, as AT1 bonds are also called, were wiped out completely when the troubled bank was unceremoniously handed over to Santander for one symbolic euro. It should have alarmed investors, alas, it didn’t, as Nordea brightly illustrates.
I do not wish to sound discouraging: many badly rated companies can gain respectability in a changing environment. Fortunes come and go. I sold my Lebanon bond when Saudi Arabia took Prime Minister Hariri, his kids and his wealth under lock, and forced him to resign in a staged broadcast. Lebanon was in disarray. When 10 days later in a meeting with President Michel Aoun he seemed to backtrack and to renounce his resignation, these bonds recovered some of their losses – for how long remains yet to be seen, but I may have been overly cautious.
A rule of thumb for professional investors in high-yield is the price difference to safe assets, like best-rated government bonds. When this so-called ‘spread’ is less than four per cent (400 ‘basis points’), junk bonds are thought not to be attractive enough. Euro junk is yielding two per cent at the moment of writing – a spread of less than 200 basis points over German Bunds, so quite clearly too expensive for investment purposes. That this does not deter even professional investors is certainly alarming.
With spreads higher than four per cent, most professionals deem it worthy to invest in junk. I think for small-scale investors like us, such rules should be taken with caution. At this time, when all asset classes are priced to perfection, any unexpected event can rock the markets. In moments of upheaval, high-risk investments will suffer most. Their prices will fall much more and much quicker than more pedestrian investments. Even a yield differential of 400 basis points should therefore not be worth the risk.
It is always better to play it safe and only invest in high-risk when we are deeply convinced we know things better than most, better than caution dictates. Do you? If the only chair left vacant in a fully-booked restaurant is the one on a crowded table of punch-drunk guests, I’d prefer to leave the place and come another time.
Andreas Weitzer is an independent journalist based in Malta. He reports on the economy, politics and finance. The purpose of his column is to broaden readers’ general financial knowledge. It should not be interpreted as presenting investment advice or advice on the buying and selling of financial products.
Please send in any suggestions for discussion in this column to: editor@timesofmalta.com – Subject: Sunday Times Personal Finance.