Over the coming months, I am conducting a real-time financial experiment designed to test the validity of the hypothesis that investments in high yield bonds (so-called “junk bonds”) systematically outperform investments in apparently safer options such as gilt-edged securities or investment grade corporate bonds.
The High Yield Hypothesis emerged from research undertaken by W Braddock Hickman, who studied corporate bond performance in the USA between 1919 and 1943. He found that a high-yield bond portfolio, provided it was sufficiently large, diversified, and held for a sufficient period of time, generated greater returns than a portfolio held in investment grade bonds. Although the high yield portfolio suffered more defaults, in aggregate the greater yield more than compensated for the losses. Hickman’s findings were updated by T. R. Atkinson, who confirmed that the same result held for the period between 1944 and 1965.
My experiment is intended to address three questions:
1. Is the hypothesis valid for the UK as well as the USA?
2. Does it apply in the peculiar monetary circumstances of 2015, when bond yields have been compressed to artificially low levels by Quantitative Easing and other Central Bank interventions in the financial markets?
3. Can the hypothesis be profitably applied by a retail investor, as opposed to a large investment bank?
The third question is, from a purely selfish viewpoint, the most interesting. During the period covered by Hickman and Atkinson, bonds were often issued in minimum blocks of £50,000 or £100,000, well beyond the means of the average retail investor. But two recent developments have enabled retail investors to participate in the corporate bond market on more or less equal terms with large institutions. The first was the creation of the Order Book for Retail Bonds (ORB) on the London Stock Exchange in 2010, which considerably increased the universe of bonds available in small denominations to the retail investor. The second was the development of Individual Savings Accounts (Isas), and an increase in their annual investment limits to £15,240 for the 2015/16 financial year. These two developments have made it possible for a small investor to build up a diversified bond portfolio in a tax-sheltered fund. The Isa incentives in particular are very important for high yield bonds. A £1,000 investment in an 8% bond would generate a net annual income of £80 if it is held within an Isa, but less than £50 if held outside an Isa by a higher rate taxpayer.
The rules of my High Yield system are as follows:
1. An equal amount will be invested in the portfolio on or about the 15th day of each month, equal to 1/12th of the annual Isa allowance. This equates to approximately £1,300 per month in 2015/16. In practice, the actual sums may be slightly higher or lower, as bonds will be bought in blocks of £1,000 each.
2. The monthly amount will be placed into the highest yielding bond eligible for an Isa, provided that there has been no prior purchase of the same bond during the financial year. This rule implies that 12 different bonds must be purchased in any financial year.
3. Bonds will be sold either when they mature, or when their yield has fallen to less than half the yield on the next bond due to be purchased under Rule 2. The funds raised from the sale will then be reinvested in this “next best bond”.
As far as possible, these rules will be applied on a purely mechanical basis.
Of all the bonds currently listed on ORB, one stands out as offering the highest yield by a clear margin – the bonds maturing in February 2022 issued by North Sea oil producer EnQuest Plc. These bonds currently trade below 70p, implying a running yield above 8% and a gross redemption yield above 12%.
Yields at this level imply that the bond market has priced in a distinct possibility of default, and with good reason. Reports suggest that EnQuest needs a crude oil price of around $80 per barrel to break even, against a current level closer to $55. The recent slump in oil prices has already claimed one casualty this month, with African oil explorer Afren defaulting on a $15 million interest payment due on March 4th “in order to preserve cash while a review of the company’s capital structure and funding alternatives is completed.” Translated into the vernacular: “Can’t pay, won’t pay.”
So there is a genuine risk of default on the EnQuest bonds. This could be averted if the crude oil price recovers, or if the company is able to reduce its cost base. The company’s senior debt providers have already relaxed their lending covenants to give EnQuest some breathing space. A White Knight may ride to the rescue, taking over the company and its liabilities; or the company’s shareholders may agree to rescue rights issue to help EnQuest through a temporary bad patch.
It must be admitted that these are an awful lot of “ifs”, “buts” and “maybes”. Yet the High Yield Hypothesis, if correct, would indicate that, if a sufficiently wide number of high risk bonds like EnQuest are built into a diversified portfolio, overall their return should more than compensate their risk of default.
So, with a degree of trepidation, the first investment of the experimental High Yield Portfolio is committed.
Issuer: EnQuest plc
Coupon Payment Dates: 6-monthly on August 15th and February 15th
Maturity date: February 15th 2022
Minimum Denomination: £100
Offer Price: 67.845
Running yield (at Offer Price): 8.1%
Yield to maturity (at Offer Price): 12.3%
Nominal Amount: £2,000
Cost: £1,366.32 + £10 commission = £1,376.32