by
Justin McCarthy | Nov 05, 2013
Key points:
1. There are two ways to access yield bonds: invest in senior unsecured bonds in smaller sub-investment grade companies or move down the capital structure and invest in Tier 1 hybrids of high quality investment grade companies
2. Swiss Re and Rabobank Tier 1 hybrids are examples of high quality investment grade companies that provide significant pick up over senior debt
For clients that have participated in the high yield FIIG origination deals over the past 14 months, there are opportunities to enhance the diversity and balance of your high yield portfolio with strong, investment grade names by moving down the capital structure into the Tier 1 hybrid level.
There are essentially two main strategies to access high yield bonds:
1. Invest in higher risk, traditionally smaller, sub-investment grade companies but take a senior unsecured position high up in the capital structure to limit the risk. This has essentially been the format for the five FIIG originated deals over the past 14 months and has resulted in bonds with high fixed rates of return at launch of 7.25% through to 8.75%
2. The other strategy, and one FIIG has advocated for much of the period since the GFC, is to invest in high quality, best of breed investment grade companies but move down the capital structure to enhance returns. In the A$ fixed income market this is essentially the Tier 1 hybrid level of banks and insurance companies. While returns are closer to the 6.0% to 7.0% mark at present, the added diversity and balance these securities can add to a high yield portfolio are valuable
Significant diversification benefits can be gained by adding allocations to these high quality names. Not only do these household financial names/credits enhance balance in high yield portfolios (which are typically constructed of smaller, higher risk corporations), they also provide the ability to choose floating rate investments which may be attractive to investors given that all the FIIG origination deals to date have been fixed rate.
Long term clients of FIIG will be very familiar with the second strategy above. This has been the thesis behind the likes of Swiss Re, NABCaps and Rabobank Tier 1s as well as subordinated debt of National Wealth, Suncorp/Vero and various other domestic banks. All of these entities are market leaders with very strong investment grade ratings. Having assessed these as very strong credits, we have been comfortable moving down the capital structure into subordinated debt and Tier 1 hybrids as long as the return compensates for the additional risk.
As a general rule, for much of 2009 to 2012 the additional returns more than compensated for the subordination, call and (in the case of Tier 1 hybrids) coupon cancellation risk. More recently this has been a case by case assessment as credit spreads have continued to tighten and the market has significantly reduced the risk premium for call risk.
From a credit spread basis, two of the bonds listed above still provide a significant pickup in return over senior debt, being Swiss Re (fixed +241bps/floating +268bps) and Rabobank (fixed +200bps/floating +252bps) Tier 1s.
There are also opportunities in the ASX listed space where there are a number of bank and insurance company Tier 1 hybrids that can provide investors with credit margins in excess of 250bps or yield to expected maturity in the range of 6.0% to 7.0%, depending on the time to call/maturity. These can fit the bill of strong companies paying an appropriate return for the additional risk of moving down the capital structure. Moreover, the overall returns will not materially impact the return on the existing portfolio of FIIG originated high yield corporate bonds.
However, investors must ensure they are being rewarded appropriately and unlike the over the counter (OTC) market which is dominated by “old style” Tier 1 hybrids, the listed market has a mix of “old style” and “new style” Basel III compliant Tier 1 hybrids. See Basel III - "new style" versus "old style" subordinated bonds and Tier 1 hybrids for a discussion of the differences.
Following extensive coverage from analysts and more recently ASIC, it appears that the listed market is now more aware of the differences in structure and risk between the new and old style Tier 1 hybrids and margins/returns are generally higher for the “new style” than the “old style”.
Adding Tier 1 hybrid securities can improve diversity and balance, with minimal impact on the return of corporate high yield portfolios.
For further information on Swiss Re, Rabobank or ASX listed options, please contact your dealer.
Note: Yields quoted are as at 5 November 2013 and subject to change.