Is junk bond market growth an opportunity for retail investors?

Published On: December 1, 2020Categories: Stocks & Shares7.4 min read

British companies issuing debt to help them survive the often steep revenue drops the Covid-19 pandemic of 2020 has resulted in has seen the market for junk bonds grow quickly this year. The rate of growth in the market has been at its second highest in a decade as riskier companies moved to secure capital.

Last year and early this year, the junk bond market was largely frozen. Investors were in risk-off mode. But as 2020 has progressed, that sentiment has flipped, with investors encouraged by the strong recovery from March’s stock market sell-off.

The British junk bond market was strong in 2017 due to pent-up demand after a slump following the Brexit vote. But by 2019 it was in the doldrums as investors worried about over-heating markets. Just $15.66 billion of junk bond debt was issued last year, according to data from financial data company Refinitiv. That stasis held over the first few months of this year, deepening in early spring as markets panicked at the onset of the pandemic.

However, the situation has since turned around completely. Numerous companies needed to recapitalise to survive the pandemic and lockdown restrictions, which often prevented them from operating. Either at all, or in a limited fashion. Investor sentiment also turned risk-on. The result has been UK and international companies with credit ratings below investment grade succeeding in issuing $29.1 billion of debt through the high-yield ‘junk bond’ market.

It’s seven years since junk bonds were issued to a similar value. Ordinarily, investors would have been more nervous of risky debt. And in February and March that was very much the case. There were concerns that a tidal wave of corporate debt defaults could hit. However, central bank intervention changed things. With companies given access to low and interest-free government-backed loans, fears receded and a strong junk bond market rally took hold.

With junk bonds often paying up to 6% or 7% and higher, are they an attractive prospect for retail investors? Or too risky an asset class for smaller investors and one to be avoided?

What are junk bonds?

Junk bonds are issued by companies whose business profile and existing debt means their creditworthiness is rated by the main credit agencies, Standard & Poor’s (S&P), Moody’s & Fitch, as falling short of ‘investment grade’.


Source: Corporate Finance Institute

Because junk bonds have a riskier status than investment grade equivalents, they offer higher interest rates. That means junk bond investments can be very profitable for investors. If, of course, issuers do not default. It’s the higher risk of that happening that means higher returns have to be offered to entice investors.

Just How Risky Are Junk Bonds?

Not all junk bonds are created equally and there is a significantly different risk profile between BB+-rated junk bonds and C-rated junk bonds.

S&P Global’s 2018 Annual Global Corporate Default and Rating Transition Study, provides statistics on exactly how often bond defaults occur. As would be expected, the S&P data demonstrates that the default rate on investment grade bonds is significantly lower than that of non-investment-grade junk bonds.

According to the study’s data, a AAA-rated bond has never defaulted – not once. The highest one-year default rate for AA-rated bonds was 0.38%. The highest annual default rate was 0.39% for A-rated bonds and 1.02% for BBB-rated bonds.

Below bonds with investment-grade credit ratings, that leapt considerably to 4.22%, 13.84% and 49.28% for BB, B and CCC/C-rated bonds respectively. It should be kept in mind that those default rates are for the single year with the highest default rates on historical records.

Junk bond investments, towards the upper end of the credit rating scale, are not hugely risky investments. A worst case default scenario of under 10% could be tolerable for retail investors as part of a smaller allocation to higher risk, higher reward investments. Though it should be noted that risk should be spread, either by investing in multiple junk bond offerings independently, or through a fund that spreads capital across tens to even hundreds of issuers.

Which UK companies have been issuing junk bonds this year?

Some big British companies have this year insulated their balance sheets through the high-yield, junk bond market. They include Jaguar Land Rover and Rolls-Royce. In Europe, the likes of retailer B&M have also issued high yield debt. And there are plenty others, mainly from sectors hardest hit by the Covid-19 pandemic, such as cruise operator Carnival, Premier Inn-owner Whitbread and even Marks & Spencer.

Investor interest has been supported by mass intervention by governments and central banks. Speaking in The Times newspaper, Jonathon Butler, head of European leveraged finance at PGIM Fixed Income, a division of American insurer Prudential Financial, commented:

“Governments and central banks have really stepped up to the plate. That has provided a huge level of support and confidence that they are prepared to do what it takes to get through.”

Despite the fact that vulnerable companies unable to trade, or at a reduced level, over the past months have been forced to pay up to 10% or 11% on bonds, almost double usual levels, Mr Butler says his company is confident only 2% to 3% of junk bond issuers would fail to meet commitments next year.

That’s a pretty good default rate considering the returns on offer, especially if investors spread their risk and don’t over-expose themselves to a small number of junk bond issuers.

How to invest in the junk bond market

Investment grade bonds can often be bought and sold via a stockbroker, much like shares. The London Stock Exchange lists traded bonds. But junk bonds are not listed and traded via an exchange. Investing in junk bond issues directly means buying from the issuer. With minimum investment levels usually in the millions of pounds, that’s not practical for private retail investors.

The best way to invest in junk bonds as a retail investor is through ETFs and funds. That also spreads the risk between many bonds, so one, or a small number of issuers defaulting isn’t such a big problem. The losses from the defaults should only slightly reduce overall returns, compensated by the large majority of issuers who keep their commitments.

UK Junk Bond ETFs

There is choice on the market so do your own research, but two of the most popular UK-based high yield or junk bond ETFs are:

iShares Global High Yield Corporate Bond GBP Hedged UCITS ETF 

iShares, the ETFs subsidiary of huge asset manager BlackRock, is one of the biggest ETF providers in the world. The Global High Yield Corporate Bond ETF is pound sterling denominated but invests in internationally-issued junk bonds. The £126 million exchange traded fund aims to track the Makrit global developed markets liquid high yield index.

Holdings include T-Mobile-owned Sprint Corporation and Ford Motor. The fund targets a yield of 6.5%.

JPM Global High Yield Corporate Bond Multi-Factor UCITS ETF

Managed by a three-man team at JP Morgan this junk bond ETF uses what it calls a multi-factor strategy to security selection. It doesn’t try to replicate the whole index but screens it for debt issued by companies with good value, quality and momentum.

The managers believe their approach increases diversification, lowers volatility and should enhance returns. The fund, therefore, involves some active management while still only charging a 0.35% annual fee.

As a relatively new product, investors may want to monitor its performance until it has developed a track record.

High Yield Bond Funds

Funds data company Morningstar highlights three high yield bonds funds retail investors may want to take a closer look at. They are:

AXA Global High Income

This fund invests across a global mix of sub-investment grade bonds, but the team likes companies with stable business models and predictable cash flows, which should keep default risk low.

Silver-rated according to Morningstar’s fund rating system and led by James Gledhill and Carl Whitbeck since 2012, the fund has delivered annualised returns of 4.5% over three years and yields of 4%.

Robeco High Yield Bond

The Robeco High Yield Bond fund steers clear of the lower-rated end of the junk bond spectrum, which could make it a risk-balanced option for those dipping a toe into the riskier end of the bond sector for the first time. Its top holdings include 10-year US government bonds and debt issued by companies with a strong balance sheet such as Fortune 500 company Tenneco.

The fund has a rare Gold rating from Morningstar analysts because of its below-average fees and strong performance: it has outperformed peers and its index consistently, producing annualised returns of 3.8% over five-years.

M&G Global Floating Rate High Yield

Low duration and a bias towards senior secured debt make the Morningstar Bronze-rated M&G Global Floating Rate High Yield a slightly more defensive option than typical of high-yield bond funds.

However, the portfolio does focus on bonds issued by companies with lower credit ratings, which means a greater default risk but also a higher coupon. Floating rate bonds have a variable interest rate, meaning the coupon you receive from the investment will change over time.

The advantage of this approach is that if interest rates rise, the coupons are automatically adjusted upwards. However, the coupon will also be cut if rates fall.

The fund is run by James Tomlins with deputy manager Stefan Isaacs, both of whom have established a good track record across a number of high-yield funds. This fund has returned annualised returns of around 2.7% over five years and yields 3.8%.

The fund has the flexibility to invest across the globe. It’s only rated Bronze as at 0.83%, its annual fee is higher than many other junk bond funds. But for those looking for a more defensive option, that slight premium might be worth considering.

About the Author: Jonathan Adams

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