Market Insight

Investing 103: Enjoying the sweet life
Friday, November 24, 2017

Anyone reading this article is probably familiar with the advertisements used to sell the virtues of corporate bonds. The advertisements are typically aimed at investors who may be classified as high net worth individuals or alternatively, they have their own (sizeable) self-managed superannuation fund.

Usually there is a picture of a few relatively young active retirees engaged in some enjoyable social or sporting activity. The picture conveys the impression that they are carefree and having the time of their lives.

The subtext is that they are not worried about the volatility of their share portfolio because they have invested in ‘low risk’ corporate bonds. The reality of course, is somewhat different. 

Investing in corporate bonds and even government bonds has its challenges as has been discussed in the Investing 101 and Investing 102 articles. Two considerable challenges yet to be considered are information flow and liquidity.

Liquidity and Information 
The easiest and most accessible option for investing in corporate bonds is to look at those listed on the ASX. Buying and selling bonds listed on the ASX is much the same as buying and selling shares. 

The market has reasonable depth and therefore liquidity. Unless you are looking to transact in very large amounts, buying or selling is as easy as making a phone call or placing an order on-line with your broker.

As for information flow, issuers of listed bonds must meet the same continuous disclosure requirements as those companies with listed shares.

The problem with this market is that relatively few bonds are listed on the ASX. All bonds issued by the Commonwealth government are listed, but no state government bonds are listed and there is just a handful of corporate bonds and hybrid securities.

The capital value of the listed corporate bonds and hybrid securities is less than A$50 billion and this year the size of the market has been declining, as redemptions have exceeded new issues.

Many, many more bonds are traded in the wholesale over-the-counter (OTC) market.

In the investment grade market, the capital value of the corporate bonds available exceeds that of those listed on the ASX by almost a factor of ten. And the opportunity for diversification is considerably greater, with bonds being issued not only by Australian banks and companies but by banks and companies from all around the world. 

Markets for institutional and retail investors 
As the name implies, this market is only for issuers that carry investment grade credit ratings. So default risk is very low and so too are the coupons paid on the bonds. At the present time, available yields range from less than 2.0% to less than 5.0% per annum. 

This is a market for institutional and sophisticated investors. Trading is in minimum parcels of A$500,000 at a time (and generally more) and liquidity and information flow are constraining factors to some degree.

Over the counter (OTC) trading means that if you want to buy bonds you need to find a seller or a broker with some inventory and conversely, if you want to sell, you need to find a buyer or a broker that wants to expand their inventory. Price discovery can be a problem, along with trying to get set in the desired volume.

Information flow is also problematic with there being minimal reporting requirements. However, this is mitigated to the extent that the issuers are typically very large entities for which information can often be readily found.

But investors will need to take on the responsibility of monitoring their exposures. 

High yield bonds
There is also another wholesale OTC market where liquidity and information are much more problematic. This is high yield (junk bond) market – a small but very opaque market. 

This is a market for specialist fixed income brokers and for better or for worse, their clients. Bond issuers in this market are typically smaller Australian companies and financiers that don’t have a credit rating and do not necessarily have shares listed on the ASX.

The attraction of this market for investors is the high yields on offer. Yields will typically exceed 7% per annum and go as high as 10% and maybe even more.

The yields are this high because the issuers are high risk. Unrated issuers are unlikely to attract an investment grade credit rating, if they were to be rated.

And for these bond issues there will often be little or no liquidity to facilitate secondary market trading. Typically, the only broker that will deal in the bonds will be the broker that bought the issue to the market in the first place.

Information flow may also be very limited, inhibiting investors’ ability to monitor their exposures. If the issuer is a relatively small private company, information may be limited to whatever the company has undertaken to periodically make available to investors.

It should come as no surprise that this is exactly the sort of investment opportunity that is being marketed to those relatively young active retirees engaged in some enjoyable social or sporting activity.

Risks in unrated and unlisted ‘junk bonds’ 
And to illustrate the risks involved in investing in unrated and unlisted junk bonds, the plight of investors holding the bonds issued by Mackay Sugar Limited stands-out as a current example. 

Back in early 2013, Mackay Sugar sold A$50 million of five year bonds, paying a coupon of 7.25% per annum. Bondholders are unsecured and rank behind the company’s bankers, who hold fixed and floating charges over everything.

The intervening years have not been kind to Mackay Sugar and the company has reported mounting losses for the past three. The bonds are due to be redeemed next April and the company is now frantically trying to sell assets so its obligation to redeem the bonds can be met and default avoided.

Investors are not optimistic about the company’s prospects. Its bonds are now marked on the sponsoring broker's rate sheet at little more than 50 cents in the dollar.

Still, this could be a great opportunity for any investor with a high risk tolerance. If the bonds are redeemed when due, an investor buying the bonds now would enjoy a yield to maturity of more than 230%.

That’s assuming the sponsoring broker actually has any bonds to sell.

Philip Bayley

The author Dr Philip Bayley is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.



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