High-yield bonds: a growing market
Investors looking for yield should turn their heads to the growing domestic high-yield corporate bond market.
The market represents a small part of the overall $2 trillion Australian bond market, but it’s growing and offers equity-like returns with all the benefits of bonds – known income, expected repayment of capital at maturity, diversification, and of course, bonds are lower-risk than shares in the same company.
In the five years to 30 June 2018, high-yield bonds worth $3.69 billion were issued across 63 deals, the majority in the over-the-counter market. In the last year, 16 were issued worth $712 million. The market is growing as banks tighten lending standards, restricting loans to some parts of the market, such as property and coal-related industries, requiring companies to find other debt solutions. While some companies issue bonds for stability and certainty of funding, bonds can be issued for longer terms than traditional bank funding - up to ten years.
Importantly, for companies reliant on just one or two banks for funding, it’s also a way to diversify funding sources.
There have been some well-known high-yield issuers including Qantas, AfterPay, NextDC and G8 Education. Qantas’ improving results have seen its bonds return to investment-grade status. Excitingly, Virgin Australia, who has traditionally issued into the US high-yield market, issued in the Australian market for the first time earlier this year.
By way of background, unrated and sub-investment-grade bonds are typically referred to as high-yield bonds, which means they are not rated or hold a rating of ‘BB+’ or below by rating agencies S&P and Fitch, or ‘Ba1’ by Moody’s.
Two recent issues
Two recent issues by FIIG Securities were listed off-grid energy provider Zenith Energy and national private legal group, Maurice Blackburn, the deals raising $40 million for each company.
Zenith Energy is headquartered in Perth and specialises in providing remote power generation to the resources and energy sectors in remote areas not connected to the electricity grid. Customers include US blue-chip oil and gas producer Chevron and ASX-listed Incitec Pivot.
Zenith raised the $40 million to help grow the business. Investors who bought at first issue were rewarded with a fixed 7.55 per cent per annum return. The bond has a seven-year term to maturity – although like other corporate bonds can usually be traded on a T+2 day basis. Since first issue mid-August, the price of the $100 face value bond has risen to around $103, providing a higher-than-expected return to investors prepared to sell.
Privately owned Maurice Blackburn also came to the market in September with a $40 million issue. It is one of Australia’s pre-eminent consumer law firms, with almost 100 years of history. The firm has a leading position in the personal injury litigation sector and is the largest class actions practice in Australia.
Given the recent Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and the likely class actions that will ensue, Maurice Blackburn wanted to find an alternative source of funding away from the major banks. Maurice Blackburn bonds pay a fixed rate 7.45 per cent per annum and have a shorter four-year term. They pay quarterly interest, great for investors looking to build cash flow. Like Zenith Energy, the bonds have performed well since first issue, also trading at a premium to $100 face value.
Structure and subordination
Higher-risk companies can offer specific assets to secure a bond issue, reducing the cost of funding and decreasing the risks for investors.
So, you can have bonds that are issued by the same company as being senior secured and investment-grade, implying low risk. But the same company can issue unsecured bonds, being higher-risk, but earning higher returns to compensate.
An example here is Newcastle Coal Investment Group (NCIG). NCIG holds the long-term lease on the NCIG coal export terminal at the Port of Newcastle and was formed in 2004 by four coal producers in the NSW coalfields.
NCIG chooses to issue bonds into the US market. It has a high-yield bond maturing in March 2027 that has an 8.2 per cent yield to maturity and also a secured investment-grade bond, which is lower risk, yielding 5.25 per cent if held to maturity, also in 2027.
In the case of a wind-up or liquidation, the secured bonds would have recourse over the secured assets and be paid out prior to the unsecured bonds. The secured bonds sit higher in the capital structure which liquidators must follow, ranking investments in priority of payment. Thus, the secured bonds are lower-risk and provide a lower return. Both bonds are long-dated and fixed-rate, and prices would fall if interest rates rise.
Protections for bondholders
High-yield bonds have a variety of bondholder protections aimed at retaining as much cash flow within the company as possible to service the debt obligation. This may be achieved by limiting the amount of debt, or restricting payments such as dividends to shareholders.
Summary
Development of the high-yield bond market in Australia is an important part of the market. It supports economic growth and mid-sized companies with ongoing working capital to grow and develop. For investors, it provides the opportunity to help fund local companies while earning high yields.
Elizabeth Moran is director of education and research at FIIG Securities.
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