High Yield Bonds and the Efficient Market Hypothesis

The proposition that investments in high yield bonds will generate returns that are greater than could be secured from other investments is contrary to the Efficient Market Hypothesis (EMH). If the EMH is correct, then it should be impossible for an investor in high yield bonds to generate excess returns.

So the performance of the experimental High Yield Bond portfolio will, indirectly, also be a test of the EMH.

Even if one believes that financial markets are not always efficient, it does not follow that they are always inefficient. My experience over the years has led to a healthy scepticism regarding the EMH in its strongest form; but most of the time, security prices quoted on a liquid and competitive market such as the London Stock Exchange seem to reasonably reflect publicly available information.

The question addressed here is whether the third addition to the High Yield Bond Portfolio is efficiently priced.

Raven Russia (RR) describes itself as “a Guernsey registered property investment company specialising in commercial real estate in Russia.” So an investor in RR is, in effect, taking a macro position on the Russian economy. In its most recent stock market update, RR sought to reassure investors that it is more than capable of riding out any temporary turbulence in Russia for three main reasons. Firstly, the vast majority of its tenants are locked into dollar-denominated leases. Secondly, the company has adequate dollar cash reserves to meet its ongoing financial commitments. Thirdly, the current turbulence in Russia has led to a general cutback in new property investment, so there is “limited new space coming onto a structurally undersupplied market.”

The way RR tell it, you could be forgiven for concluding that Vladimir Putin’s aggressive foreign policy is a positive boon for their investors.

I don’t buy it.

While RR’s tenancy agreements may be denominated in dollars, this does not tell us how easily their tenants will be able to meet their dollar obligations, or for how long. Raven Russia is by no means the only company to have been hurt by Putin’s foreign policy, which is damaging the interests of his own people and the wider region. The fact is that RR has no more control over Russia’s erratic leader than I do.

An investment in Raven Russia only makes sense if wiser and more prudent heads within the Kremlin have the courage and capability to restrain Putin, and if the honourable efforts of President Hollande of France and Chancellor Merkel of Germany to broker a peace deal in the eastern Ukraine bear fruit.

It could happen, and I hope it does. But there are no guarantees whatsoever that it will.

Furthermore, the terms accruing to Raven Russia’s preference shares are not particularly favourable to their investors. While the 12p per share dividend will remain payable for the indefinite future, the shares can be redeemed at 100p per share in the event of a winding up, takeover or merger. Although there is no immediate prospect of such an event, were it to happen, a holder of the preference shares would face an immediate and significant loss of capital, even if Raven Russia itself is solvent.
Thus, while a running yield of 8.5% may look attractive, it does not come without risks, and I believe that the current market price fairly reflects those risks – indeed, depending upon one’s view of Putin’s Russia, it may actually under- discount them. Given these considerations, normally I would not be rushing to buy these securities. However, the rules of the High Yield Bond Portfolio are set to override personal judgement. So the Raven Russia preference shares become the third security added to the portfolio.

Issuer: Raven Russia Ltd
Security: Cumulative Redeemable Preference Shares 1p
Coupon: 12.0%
Payment Dates: Quarterly on March 31st, June 30th, September 30th and December 31st
Maturity date: Undated, but redeemable at 100 in the event of a winding up, takeover or merger
Offer Price: 141
Running yield [RY] at Offer Price: 8.5%
Yield to maturity [YTM] at Offer Price: 8.5% [The YTM on perpetual or undated securities is the same as the RY]
Nominal Amount: £1,000
Cost: £1,410.00 + £5.75 commission = £1,415.75

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