Preflight Check for High-Yield Investors

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser. What are the ramifications of investors continuing to go down the credit quality spectrum to find higher yield?

I am here with senior securities analyst Dave Sekera to take a look at this question.

Dave, thanks for talking with me today.

David Sekera: You're welcome, Jeremy. Thanks for having me over.

Glaser: So I have the data that you've seen shown that investors really are kind of reaching for that extra couple of percentage points of yield by taking on riskier bets.

Sekera: Yes. We have seen an increasing number of individual investors who have been purchasing high-yield, also know as junk, bonds. These are bonds that are usually BB rated or below. So, as we take a look at the amount of trades that are out there, and we look specifically for trades that are $100,000 or less per trade, we identify those as being retail trades, and we see that through FINRA, the Financial Industry Regulatory Board, that all of the trades get reported through.

Glaser: So as we have individuals going after these junk bonds, going into areas that were traditionally reserved for institutional investors, do you think that there is risk there that people might not completely understand?

Sekera: There is definitely additional risk there. So, as you go down the credit quality spectrum, it becomes increasingly more important to make sure that you do your own due diligence, understand the credit risks that you are taking, and then there is also some other technical risks that are involved in investing in the high-yield market. It is a little bit less liquid market. There can be additional commissions. There can be additional markups when you look to go and buy and sell different types of bonds.

Glaser: Now, Morningstar, when you talk about fixed-income investing, we often talk about looking for wide moat companies, looking for fortress balance sheets. Those are things that you don't find too much in the high-yield space. So if you are looking to do due diligence, what are some of the things you would want to look at, at a potential high-yield purchase?

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Sekera: It's exactly true. So, usually we do try and recommend investors if they are buying individual bonds for their own portfolios, wide-moat companies, strong free cash flow, balance sheets that are just fortresses, things where you don't have to be worried about the credit quality of the company deteriorating very fast. By definition a high-yield company is not going to have those same characteristics.

So, when you go and do your due diligence, in addition to looking at the historic financial metrics, you want to have an idea of what the cash flow of the company is going to look like. You also have to take a look at what the capital structure of the company looks like. High-yield companies typically have different types of securities that have different claims on the assets of the company.

So, if the company were to go on bankruptcy, you usually have the bank debt which comes first and has to get paid off first. That usually has a senior secured claim on the assets. The high-yield bonds are often senior unsecured bonds; they get paid next. And then you have the subordinated bond layer, who are the last in line to get paid.

So you want to make sure you understand where you are there, and you also want to make sure you understand how much leverage there is, how much debt there is at each portion of the capital structure. So ideally you want to try and find the area where you get the most spread per amount of leverage that you are taking on for each individual company.

Glaser: Certainly the extra yield you're getting is not free. Obviously you're taking on extra risk. Is this a case where it might make sense to look at a high-yield bond fund or to look for a professional manager?

Sekera: Well, it depends on the individual investor. For individual investors that are relatively sophisticated, are comfortable digging around the balance sheet, being able to put together their own kind of projections for the amount of cash flow, I do think those type of investors can get involved in the high-yield universe.

For individual investors that just aren't comfortable with balance sheets, really going through financials, being able to kind of put together their own ideas of where they think companies are going, in that case I do think you are better off going with professional management.

Glaser: For investors who do have the financial skills, who have the financial background, and want to dig in to it, what kind of tools does Morningstar offer?

Sekera: Well, first of all we do have our own credit ratings business. We have over 600 issuers that we provide individual credit ratings on. That 600 is growing. It's going to be at least 700 by the end of the year, and that credit rating universe does include a number of below-investment-grade issuers.

So, we started off, we do provide our credit perspective on the individual issuer, and then you can also then use the website in order to look at their historical profitability, take a look at the credit metrics of the company, be able to kind of understand how has this company performed over the past, how has it performed over prior recessions, and get an idea of how much variability there is in the company's cash flows.

In addition on the website we do have a bond tab. Within that bond tab, we do have pricing on individual bond issues. So I'd recommend anyone to check the pricing before they were to actually buy in the open market. There is a wide variability out there in how bonds are priced. So just make sure you don't get taken advantage of.

And also, there is a debt distribution schedule on there. So you can look and see when maturities are coming due for the individual investors and the size of those maturities. You want to make sure that you stay ahead of maybe any potential refinancing risk in the future, maybe buy a deal that comes due a little bit shorter than maybe a longer-dated deal which has a very large maturity date coming up.

Glaser: Certainly an area where you're doing your research should pay off.

Sekera: Exactly. But when we do take a look at the extra yield that's out there, it is definitely attractive. So with the five-year Treasury at 1% right now, the 10-year Treasury bond at 2.5%, let's just put it like a normal single-A rated type credit out there, you probably get about 100 basis points over Treasuries. That's 3.5% for 10-year money that you are locking up, whereas if you look at a BB rated company, which should be the highest level, or BB+ company, which is the highest level below investment grade, you can pick up an additional 400 to 500 basis points over Treasuries that at least gets you to a 6.5% to a 7.5% range.

Glaser: Dave, thanks so much for taking the time today.

Sekera: Well, thank you.

Glaser: For Morningstar.com, I am Jeremy Glaser.