Invesco: Hunting for opportunities in second-hand bond markets

When a bond is issued, its price is usually set at 100 and a coupon is agreed – this is the amount the lender will pay each year as reward to the borrower until the bond matures and the debt is repaid. The higher the investment risk, the higher the coupon. Simple so far, but what happens next is where things get interesting.
 

What are second-hand bonds?

After bonds are issued, they can be bought and sold on what are called secondary markets. For the smart active investor, especially those operating in high yield markets, these “second-hand” bonds can be a source of opportunity.

High yield bond markets are not as straightforward as, for example, large-cap equities, where well-known companies are traded and there is just one line of stock for each market. Many high yield bond issuers are smaller or privately owned. Each company can have a whole series of bonds of different duration and often issued in different currencies. It can get complicated. The market is less well-researched, and that means there is a greater likelihood of bonds being mispriced.

If the market becomes anxious about a company’s ability to repay its debt – or anxious in general – the price at which the bond trades may fall some way below 100. If interest rates rise and the coupon – which is fixed – no longer looks as attractive as it did when the bond was issued then the price at which the bond trades will also dip below 100 to compensate. Generally, though, as the bond comes close to maturity it will return to “par” – because investors become increasingly confident that they will shortly get their money back in full.

For a moment, uncomfortable though it may be, remember the tumult of 2022 – Covid restrictions in China, supply chain issues and the war in Ukraine, which sent energy prices into orbit. Inflation took hold, and interest rates rose as central bankers tried to rein it in. Those rising rates, coupled with the overall uncertainty, meant bonds took a tumble.
 

Is now an attractive time for bonds?

Markets have recovered a little since then, but high yield bonds are still trading at an average of around 88. If you combine the coupon payments and the assumed pick-up as the bond price gravitates back to par, the yield to maturity on offer now in Europe is around 7.5%¹. Back in January 2022 it was just 3.4%.

Though that may look attractive, we must take into account the heightened risk of companies defaulting on their loans. Lenders are ahead of equity holders in the queue for repayment when a company enters into administration. Consequently, on average, senior unsecured bond holders have historically recovered around 40% of their money.

This is a comfort, but investors want to avoid such a situation if possible. This is where good active management comes in. We can mitigate risk by diversification and good research – checking a company’s creditworthiness before buying bonds and constantly thereafter in case anything changes, either for the company directly or the environment in which it operates. Good research can also unearth great opportunities – especially in those secondary markets.

There is one more thing we have to consider in the current environment of rising interest rates – when the bond matures, can the company borrow again and cope with the likely higher costs of debt?
 

How are new bonds issued?

An example may help to bring this issue to life. Swiss-headquartered alarm and security company Verisure is a global leader in its field. In September last year it came to the market to refinance its bond, which matures this year and had a coupon of 3.5%. The company succeeded, but its new bond, which matures in 2027, has a coupon of 9.25%. It must pay 9.25% a year on this bond for four years. We participated, believing that an income of 9.25% looks attractive compared to other investments, and that Verisure can cope with the higher costs.

But others may struggle. A company’s ability to repay existing bondholders at maturity could depend on whether it can borrow fresh funds. 

We still think there are bargains in the secondary markets, but good credit research and diversification are vital to maximise the opportunities and reduce investment risk.

¹ICE BofA European Currency High Yield Index, 22 February 2023

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Debt instruments are exposed to credit risk which is the ability of the borrower to repay the interest and capital on the redemption date. Changes in interest rates will result in fluctuations in value and investments in debt instruments of lower credit quality may result in large fluctuations in value.

Data as at 14^th March 2023 unless otherwise stated.

This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. 

Views and opinions are based on current market conditions and are subject to change.

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