Investing in select high-yield corporate bonds (NYSEARCA:HYG), a.k.a. "junk" bonds, can be lucrative, with some bond issues offering equity-like returns with less downside risks and lower volatility compared to stocks. The appeal of these higher-yielding bonds (particularly in this low yield environment) has attracted a wide range of investors. With that in mind, let's examine 5 common mistakes that are made, amongst novice and veteran high-yield investors alike, in the world of junk bond investing.
1.) Using Credit Ratings for Pricing Guidance:
I can't tell you how many times I've heard an investor say that "this bond is cheap for its credit rating" -- mistakenly thinking that this means that the bond is, therefore, priced attractively. Such a reliance on ratings from agencies such as Moody's Corporation (NYSE:MCO) and McGraw Hill's (MHFI) Standard and Poor's, can be very dangerous, given the nature of credit ratings and their tendency to substantially lag market prices.
While corporate bond credit ratings have done a good job of predicting defaults (in aggregate for a large number of issuances; as is evidenced by the agencies' default studies), the accuracy of any individual bond rating, relative to market yields at any one point in time, can be very poor.
This is because the rating agencies don't react in real-time, like the market does, and they must go through a time-consuming and systematic process (comprised of issuer meetings, rating committees, etc.). Furthermore, their aim is not solely to have the most accurate rating at any point in time.
Rather, the rating agencies must also consider the stability of their ratings and the need to see through the cycle, since neither investors nor bond issuers want too much ratings volatility. Finally, since the rating agencies are loathe to make that final jump from one major risk category to the other (i.e. investment-grade to high-yield/junk or vice versa), you end up with a lot of credits on either side of the "border" that should have moved across a long time ago.
For all these reasons, when there's a disconnect between the rating agencies and the market, I believe that the market is typically right. In fact, I would argue that bond issues that appear cheap, relative to their ratings, are often actually expensive because of the buying pressure that the ratings disconnect can have on the bond price (i.e. buying pressure from those mistakenly buying primarily because of the bond's apparent cheapness relative to its credit ratings).
2.) Focusing On Current Leverage and Ignoring Borrowing Potential:
Some investor focus on a H.Y. issuing company's current leverage without adequately considering the potential leverage and dividend leakage that is allowed under the covenants of the issuer's bond indenture. While the bond indenture of a H.Y. corporate bond can be an intimidating mass of legalize (and much is boilerplate stuff without a great deal of difference between issues) there are two covenants of particular importance, where investors should focus much of their covenant-review efforts. These are the "debt incurrence" and the "restricted payment" tests.
The debt incurrence test is the covenant which restricts how much debt a company can incur. A key to high-yield bond investing is having a healthy level of skepticism and you should generally assume that an issuer will use the capacity that they have afforded themselves under the bond indentures.
There is a price that the issuer pays for this borrowing flexibility (the weaker the covenant protection, the higher the yields that the issuer must pay). For that reason, and for the purpose of general conservatism, you should treat the borrowing capacity as something that the issuer could likely use.
The last thing you want is to wake up one morning and see that the yields of a bond that you own have blown out following the issuer's decision to make a leveraged acquisition, large share buy-back, etc. Tight bond covenants, and having comfort at the leverage levels that the bond indenture allows, can give you peace-of-mind and protection against such events. As such, try and make sure that you are comfortable with the bond's pricing/yield in a scenario where the issuer uses all of the potential leverage afforded to them.
As previously mentioned, the other very important bond indenture convent to consider is the "restricted payment test". This is the covenant which restricts the dividends and other leakage that can be paid out from the lending entity. When an issuer generates earning and/or cash flow, you want to make sure that you (as the bondholder) benefit from deleveraging and that profits and cash flow don't just get paid out for the benefit of shareholders.
With respect to both the incurrence and restricted payment covenant tests, you should not only consider the primary restrictions, but also any "carve-outs"/exceptions that are allowed. A company can have covenants that appear tight, but have generous carve-outs that allow them to borrow and/or pay out high dividends irrespective of the other limitations. This can substantially dilute the protection that would be otherwise provided by the covenants.
3.) Focusing On Leverage and Interest Ratios over Discretionary FCF:
Two primary credit ratios for H.Y. bond investors are the Net Debt/EBITDA and the EBITDA/interest ratios. While these can be useful metrics, when used in conjunction with other credit ratios, these metrics ignore the impact of capex and other cash flow items -- important items which can vary greatly across industries and companies.
For example, the cash flow generating capacity of a company with 5.0x leverage (Net Debt/EBITDA) in an industry with substantial on-going capex requirements (e.g. cable and telecommunications) can be substantially lower than that of a company with similar leverage in industries with limited maintenance capex (e.g. media and service companies).
As such, (Net Debt less capex)/EBITDA, and other ratios that adjust for capex, are more useful metrics to use for comparative purposes. Most importantly, always remember that no ratio, or combination of ratios, should substitute for a full review of all of the issuer's financial statements.
Many investors and rating agency analysts also focus on actual cash flow when analyzing the credit quality of an issuer. While actual cash flow is an important metric, the more important cash flow metric to consider is normalized discretionary free-cash-flow. This is the free-cash-flow generated that is available for investments, debt retirement, and other discretionary uses.
Actual free cash flow, and resultant ratios using that metric, treat discretionary items (e.g. dividends, acquisitions, growth capex, etc.) the same as non-discretionary items (e.g. maintenance capex, interest payments etc.). This is illogical, from a credit analysis perspective, as non-discretionary items can't be cut back or eliminated in times of need.
Secondly, always normalize free-cash flow to adjust for exceptional items. A one-off sale, expense, or working capital movement is not indicative of a company's on-going debt servicing capacity and shouldn't be treated as an on-going source/use of cash. As such, adjustments should be made to remove the impact of these items in order to better understand a company's debt servicing capacity on a forward-looking basis.
4.) Over-Estimating Default Recovery Prospects:
When investing in H.Y. corporate bonds, investors must consider not just the probability of default, but also the expected "loss-given-default". The latter is an estimation of collateral and recovery values and a resultant determination of how much investors stand to lose in a default scenario. When making such an estimation, there are several reasons why investors can tend to over-estimate recovery prospects.
Many look at the current financial situation of assets/liabilities and subordination to make their recovery assessment. This makes little sense as neither the issuer's asset/liability position nor the subordination structure (e.g. secured versus unsecured debt) is likely to be the same at the time of default compared to the non-distressed period when many investors are doing their initial credit analysis and investing.
Again, conservatism is important when estimating recovery prospects. The recovery analysis should incorporate not just the current financial situation, but also a conservative estimate of the likely cash burn and asset depletion that would likely precede a default situation, as well as the likelihood (and covenant capacity) for senior secured financing that may subordinate your recovery position over time.
5.) Ignoring Call Protection:
Because the default risk for H.Y. corporate bonds is relatively high and downside can be substantial, you want to try and make sure that there is also a good degree of upside in the event of a positive corporate event (e.g. a takeover, bond buy-back, etc.). In other words, you want invest in situations where you are paid a nice premium in the event that the bonds are taken out early.
At issuance, H.Y. bonds are typically not callable for a certain period of time and the longer that period, the greater your upside if and when the issuer decides to take the bonds out early (at which point, they typically must "make whole" the bondholders under favorable terms). All other things being equal, a bond with good call protection can be much more attractive than one without.
While the overall high-yield corporate bond market is not necessarily cheap at current levels, I believe that select H.Y. bond issuances can offer attractive risk/reward opportunities. That said, there are a number of risks and analytical factors to consider and many common investment mistakes to avoid. Furthermore, trading H.Y. bonds can be expensive (wide bid/ask spreads) and liquidity can be poor -- particularly for retail investors without access to institutional over-the-counter bond trading channels.
For all of the above reasons, I would advise many retail investors to avoid buying individual H.Y. bonds and, instead, get any desired exposure to the sector through diversified high-yield bond ETFs like HYG and (NYSEARCA:JNK). For those that do decide to purchase individual H.Y. bonds, try and avoid the common investing mistakes, discussed above, and always demand yields that incorporate not only the credit risks, but also the liquidity and transaction costs of trading these securities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.