After years of drought, savers with overnight and time deposit accounts are finally making percentages again – albeit far below inflation. An alternative: high-yield bonds, often dubbed “junk bonds.” The papers are better than their reputation, says high-yield professional Ottmar Wolf, and explains what makes the area so exciting at the moment.
FOCUS online: Mr. Wolf, interest rates are coming back – do you need “junk bonds” as an investor at all?
Ottmar Wolf: We defend ourselves against the names “junk bonds” or “junk bonds”. Behind it are solid companies. And currently the so-called credit spread is still high. That said, someone looking to earn more than 3 to 4 percent should look at high-yield bonds. In our view, returns in the high single digits are possible.
Doubters say junk, they say high interest – where does the name come from?
Wolf: The rating agencies – Moody’s, Fitch, and so on – have developed a system for assessing creditworthiness that is similar to that used for school grades. Letters indicate creditworthiness, “AAA” is the best, followed by “AA”, “A”, “BBB” and so on.
Ottmar Wolf has been working in the financial sector since 1995, has been an independent asset manager for 20 years and is currently responsible, among other things, for portfolio management at Frankfurt Asset Management AG. Before that, Wolf was a derivatives trader for DZ Bank and private customer advisor at BHF-Bank.
There is a hard boundary between “BBB” and “BB”. Professionals talk about “investment grade”, including “non-investment grade” – and between these two ratings the yield premium is particularly high. Therefore, the papers are called “high-yield bonds” or “high-yield”.
“Non-investment grade” doesn’t sound very trustworthy.
Wolf: The reputation is actually much more negative than reality. “BB” is also a very good credit rating. With this rating, there are almost no cases of bankruptcy, we are talking about defaults of 0.5 percent per year for these bonds. In other words: Over 99 percent of these companies make it!
It has to be said that the requirements for the top ratings are extremely high. “BB” and “B” are therefore still good grades. The ratings are not given away, the companies have to work for this seal of approval. Only at “CCC” do we talk about credit ratings, where bankruptcies sometimes pile up.
The fear of company bankruptcies has increased noticeably in 2022 – does this also apply to the high-yield market? What’s the mood like there?
Wolf: We feel a little reminded of Corona. The pandemic was an extreme shock, against which politicians and central banks helped a lot. The central banks have opened the money floodgates and lowered interest rates, and politicians have also distributed money. That is why the corona crash was not associated with as many bankruptcies as initially feared. Think of the travel group TUI, which the state has supported with billions in loans and guarantees.
Today we have a different crisis. The big difference: the central banks are no longer on the side of the capital markets, but are raising interest rates because of inflation. In addition, there is the energy crisis and the Ukraine war, which makes raw materials more expensive and exacerbates supply chain problems.
The recovery will therefore not be as swift as in 2020. But what we believe the crises have in common is that there will be no wave of bankruptcies for high-yield bonds.
But the stock markets have shifted into forward gear again, so why buy high-yield bonds when stocks are already recovering?
Wolf: Because of the good calculability of the “high yields”! The stock markets have already risen enormously, but whether this is interpreted as an entry or exit signal is up to you.
Shares are also always the remainder of a company’s value – company value minus debt. Investors are positioned very differently with a corporate bond. They are creditors and the company has to serve them. In addition, there is the calculability and a high return due to the currently depressed prices.
How do these returns come about?
Wolf: Typically, the bonds are issued and redeemed at 100 percent par value. The usual term is 5 years. During this time, the price can rise and fall, just like stocks.
Prices drop, especially in difficult phases, and most high-yield bonds are currently in the 80 percent range. For example, if we buy at 80 percent and still have 4 years remaining, then we get a repayment gain of around 5 percent per year. Then there is an attractive interest coupon of 5 percent, for example, making a total of 10 percent per year. The total return is roughly calculated at 12.5 percent, a very typical example.
But if prices are so low, there must be a reason.
Wolf: There are fears on the market that are not fundamentally justified. Many of these companies are fully financed and sufficiently liquid. In addition, the results in the third quarter were good almost everywhere. In our view, the fears of the market are therefore unfounded.
What you have to mention here: It’s about a niche market. With a volume of 400 billion euros, Apple alone is 5 to 6 times larger in terms of its market capitalization. Such a small market has its inefficiencies. There’s trading: At the moment we want to increase a bond ourselves – but we can’t because we can’t find anyone who wants to part with the paper!
In addition to this illiquidity, which is in no way comparable to stocks, there are other factors for the low prices. In 2022, the asset class European High Yield experienced around 15 percent net outflows – instead of the inflows that normally take place. If investors who are invested in a high-yield ETF, for example, withdraw funds, this ETF must also sell paper accordingly, which could trigger further exits. That’s why the courses have tumbled so much. For now, however, we can see that the market is finding a bottom. Hedge funds, such as Paul Singer’s Elliott Management, are already taking aggressive action.
Let’s get specific: Which papers are we talking about anyway? How does a high-yield investor know which companies are safe from bankruptcy?
Wolf: That is exactly the art of managing high yield and the core task of Frankfurter Asset Management. Generally speaking, the main reason for bankruptcy is illiquidity. Therefore, the aim is to find out whether this case could occur. Do the companies have enough cash? Lines of credit still naughty? When are debts due? And above all: How high is the equity and the so-called “leverage”. That’s the ratio of net debt to EBITDA, a proxy for operating cash flow.
When it comes to high yield and private equity investing, few metrics play as big a role as leverage. The term describes the ratio of net debt to EBITDA. Net debt is a company’s total debt minus cash reserves, while EBITDA is earnings before interest expense, taxes, depreciation and amortization. EBITDA thus reflects how well a company manages its operations. Leverage can therefore be used to draw conclusions about the level of debt and the financial stability of a company.
We also look at the business model. Does the business work, does it have the moat often advocated by investor legend Buffett, or can the world go on without this company? These questions are an important part of our “qualitative credit analysis”.
But which companies meet these requirements?
Wolf: A short disclaimer: Broad diversification is always important and we are not giving any investment recommendations here. Every investor needs to know that for themselves. But in order to give “butter to the fish”, I will outline our most recent follow-up purchases.
One of these was Upfield, our so-called “margarine bond”. Upfield is the world market leader for plant-based spreads, with brands such as “Rama” or “Becel” and started as a “carve-out” from Unilever. Private-equity investor KKR bought Upfield in 2018 with a Warren Buffett perspective: It’s a boring business, but stable cash flows and margarine is always eaten, no matter where the business cycle is.
We personally were enthusiastic about the latest quarterly figures. The bond is trading somewhere around 70 percent, with a coupon of 5.75 percent, and a term until 2026. So there’s a potential yield of 16 percent here. After two weak quarters in the first half of the year, the latest figures are sensational. This brand company has managed to raise the prices by 30 percent and thus pass on all costs. The margin is again at an excellent 24 percent.
Upfield has no shares, so the bond is the only way ordinary investors can participate in such a deal. Are there more such examples?
Wolf: There are plenty of these examples. Almost half our portfolio consists of companies that are owned by private equity and therefore there is no stock. A prominent example is TK Elevator, the former pearl of ThyssenKrupp. The steel group has sold the elevator division for 18 billion euros. The investors borrowed half of the money and attached this debt to the company.
TK Elevator is the perfect example of an “unbreakable company”. The group shares the global elevator oligopoly with three competitors, and more than 50 percent of revenues are recurring because they come from service contracts. Something like the Praktiker DIY stores, where the company is gone overnight and no one cares, can’t happen here. This is precisely why we resist the term “junk bonds”. Because TK Elevator is definitely the opposite of a scrap company.
If investors have now got the taste: How can you enter the market?
Wolf: That’s the crux. The usual denominations of these bonds start at 100,000 euros – for a truly diversified portfolio you need 2 to 3 million euros. Very few private investors have that.
We therefore recommend actively managed funds. Of course, there are also ETFs, but since these often reflect the entire market, you also use them to buy companies that eventually go bankrupt. Active managers can at least try to avoid these failures. We can proudly say: In the last 7 years we have not had a single insolvency in the FAM Renten Spezial.
And if such a bond does default, what do investors get back?
Wolf: When in doubt, more than with shares. The order is clear: first come the debts, in this case the bondholders, and only then the owners. Depending on the type of bankruptcy, the company disappears completely, as with Air Berlin or Praktiker, or the liabilities side is restructured. The bondholders then become the new shareholders via a so-called debt-to-equity swap. As a rule of thumb, 40 percent of the original debt is serviced on average if bankruptcy does occur.
