Tread carefully in the bond junkyard

For more yield – with additional risk – you could consider a TransAlta Corp. 6.9% bond due Oct. 22, 2029, recently priced at $86 with a 8.58% yield to maturity. That issue was rated Baa3 by New York-based Moody’s Investors Service Inc., equivalent to a rating of BBB- from Standard & Poor’s Financial Services LLC (S&P) or Fitch Ratings Inc., both of which are also based in New York.

The Bell Canada and TransAlta bonds are at the bottom of the investment-grade scale. If your clients are seeking higher returns, that has to be matched with rising default risk. There are two distinct tiers in high yield: materials and energy companies; and others not tainted by collapsed oil and commodity prices.

Junk bonds are under pressure. In early December, New York-based Third Avenue Focused Credit Fund, a specialist in bonds rated CCC (“vulnerable in downturns,” as S&P puts it), announced that it would shut down its US$788-million portfolio and delay return of cash to investors. Bonds rated CCC have seen their yield spread over U.S. treasuries widen by 750 basis points (bps), 200 bps of which happened between mid-November and mid-December 2015. The once high-flying fund not only closed its doors, but told investors on Dec. 11 that it would be months or perhaps more for investors to get their money back.

An even more exotic bond fund specializing in distressed debt, New York-based Stone Lion Capital Partners LP, suspended redemptions after many investors demanded their money back.

For clients with an appetite for risk, metals miner Sherritt International Corp.’s 7.5% issue due Sept. 24, 2019, with a B rating from DBRS (“highly speculative” in its lexicon), was recently priced at $43.15 to yield 36.67% a year to maturity. The exceptional return on the Sherritt bond reflects a concern in the market that the company may not be able to make required coupon payments. Sherritt shares traded above $25 in 2008 and recently sagged to $0.73, with a reported net profit margin of negative 128%.

The Sherritt bond issue is not alone in being deeply discounted. The high-yield market is headed for its first annual loss since 2008, dragged down in part by a prolonged slump in oil and other commodity prices. However, average yields in the mostly U.S. high-yield market have risen to about 8.3%, a four-year high, according to Bloomberg LP.

For the junk bond market as a whole, the risk premium on the Markit CDX high-yield index, a credit-default swaps benchmark, rose to 514.52 bps – the highest level since December 2012. Meanwhile, BlackRock iShares iBoxx High Yield Corporate Bond ETF, a junk-bond exchange-traded fund (ETF), fell to its lowest levels since 2009. In a widely quoted December 2015 statement, famed investor Carl Icahn pronounced his judgment: “The meltdown in high yield is just beginning.”

Much high-yield debt already has fallen in price, along with the energy and materials subsectors, even though the risk of default in those subsectors is much lower than for resources. The decline is creating real opportunities. For example, garbage collector GFL Environmental Inc.’s 7.5% bond due June 18, 2018, has a DBRS rating of B and recently was priced at $100.30 to yield 7.31% to maturity. And Parkland Fuel Corp.’s 6% bond due Nov. 21, 2022, with a DBRS rating of BB recently was priced at $100 to yield 6% to maturity.

So, is junk a screaming bargain? Or a reason to close the doors and hide the children? According to Adrian Prenc, vice president with Marret Asset Management Inc. in Toronto: “High yield is oversold if you do not believe that there is a recession coming.”

The intrepid client interested in having a junk portfolio put together should do so as an addition to other debt, Prenc adds: “This is an asset class where you want a balanced portfolio.”

His advice is to use a barbell of short and long maturities with a conservative core fixed-income portfolio in which a small portion is high-yield. ETFs and managed funds can provide the liquidity and diversification in this market, he adds.

It’s possible to step aside from the problems of picking conventional bonds and to choose real-return bonds (RRBs). These bonds, issued by the Government of Canada, provinces and a few agencies and Crown corporations, typically have long maturities and behave much like long bonds, but coupon payment is set to the headline inflation rate.

RRBs are prized by life insurance companies for the bonds’ built-in ability to keep pace with inflation and thus keep track with payment obligations on indexed pension plans. For the 10 years ended Nov. 30, 2015, RRBs posted an average annual compound return of 3.12% a year. Yet, on a year-over-year basis, RRBs’ performance has been choppy, averaging a 10.44% gain in 2014 and a 13.13% loss in 2013.

Clients buying an RRB, through an ETF, a managed fund or as an actual bond, need to know the inflation assumption of each RRB issue or the RRB portfolio average. RRB break-even rates recently have been at 1.55%. If inflation runs above that level – say, at the Bank of Canada’s target rate of 2% – the bonds will beat conventional bonds and return a rising profit as inflation ratchets upward. RRBs ultimately are a speculation on the long end of the yield curve.

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