US high-yield bonds offer choice and depth

Government bonds have been on the nose since Trump sent prices lower last year on the promise of tax cuts and increased spending.

Corporate bond index

Government bonds have been on the nose since Donald Trump sent prices lower last year on the promise of tax cuts and increased spending.

But the underlying corporate bond market continues full steam ahead, with demand massively outstripping supply.

So much so that blue-chip, AAA-rated technology giant Microsoft was able to get the year’s biggest bond transaction just a few days ago. Microsoft raised $US17 billion ($22bn) to refinance commercial paper used to fund the acquisition of LinkedIn and fund general corporate purposes, including share buybacks and capital expenses.

Despite the size of the transaction, some investors were left empty-handed with demand rumoured at $US38bn.

Our domestic corporate bond market mirrors that of the US in that demand far exceeds supply. Consequently, bond prices are rising and expected returns compressing. New investors may have to wait for reluctant sellers before they can access the bonds they want.

Typically, I would suggest to new investors they should expect to earn 1 to 2 per cent a year more than deposits for a low-risk, investment-grade bond portfolio, putting the expected yield at between 3.8 and 4.8 per cent a year. Not terribly exciting, but there are ways to improve returns for those willing to accept higher risk.

One of the best strategies at the moment for wholesale investors is tapping the US high-yield market where returns can be as high as 10 per cent a year.

The US high-yield corporate bond market is huge: worth about $US1.4 trillion of a total corporate market of about $US8.5 trillion. Issues sizes are usually large and provide good trading liquidity.

Many companies issuing bonds are listed, with good news flow and visibility over market capitalisation. I like those sectors with physical assets such as telecommunication and power generation.

If Trump succeeds in his proposed stimulus measures, both of these sectors are likely to benefit from improving business conditions. An example of a corporate bond in favour is McDermott International, a global engineering, procurement, construction and installation business providing services for upstream oil and gas developments. McDermott has a fixed-rate bond due to mature in May 2021 that has a current yield to maturity of just less than 6 per cent per annum. The $US100 face value bond traded as low as $US63.50 in February 2016, but it has rebounded and is now trading around $US104.50.

The fluctuation reflected the company’s exposure to oil prices, which dropped about 75 per cent over the same period. These bonds may be quite volatile but as long as the company continues to operate, investors can expect a return of $100 face value at maturity. For this company, volatility is somewhat mitigated by a strong backlog of work worth $US3.9bn as at September 30 last year.

The stellar move in the McDermott bonds along with others exposed to commodities — helps explain the 21.17 per cent return in the Bloomberg USD High Yield Corporate Bond Index last year.

There are significant risks involved in investing in the US high yield bond market, including currency and interest rate risk. However, as much of the return is a margin for credit risk (that is the possibility of the company not being able to pay interest or return capital at maturity), changes in interest rates are less likely to impact the price of the bonds, compared to government bonds that solely reflect changes in interest rates.

Government bond yields are a benchmark and the rising US 10-year yield has largely been mimicked by the Australian government 10-year yields on an upwards trajectory.

Both bonds have risen about 1 per cent from last year’s lows to 1.46 per cent for the US and 2.72 per cent for the Australian bond. It’s worth remembering that the yields convey what the markets expect, and will not necessarily eventuate.

Even though these benchmarks have moved higher, global demand for corporate bonds has pushed the spread over the benchmarks down, lowering overall corporate bond returns. This is illustrated by the Bloomberg USD High Yield Corporate Bond Index, up 21.17 per cent in 2016, up 1.61 per cent to December, averaging 5.13 per cent over the past three years.

The US high yield bond market presents more choice and potentially more depth than the Australian market but if anticipating volatility, timing of entry and product selection will be key.

The domestic corporate bond market is underdeveloped and I expect many Australian companies to continue to issue in US dollars where they can access larger volumes and often at better yields than what can be achieved in Australia.

Elizabeth Moran is a director of education and research at FIIG Fixed Income Specialists.

www.fiig.com.au