Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 71

Why would you invest in junk?

The Australian bond market made history this year. For the first time a company whose credit rating is below ‘investment grade’ – often colloquially called ‘junk’ - successfully raised funds by selling Australian dollar bonds publicly in the institutional market. The company issued $300 million of 7 year bonds in May 2014, then returned to raise another $400 million in June through an 8 year issue.

Many readers might be wondering why anyone would invest in ‘junk’. In this case there are some unique reasons, but the issuing success of this company provides an opportunity to explore the investment case for high yield bonds.

The issuer and the yield

One of the reasons for the success of these deals is the familiarity of the company to investors. After all, Qantas is a household name! Not only is Qantas the ‘national carrier’, but it’s listed on the ASX and held in many share portfolios. Further, Qantas has been an issuer in the bond market before, so its credit fundamentals are well known to fund managers.

In fact, credit analysts looked at the airline relatively recently. In April and May of 2013, Qantas raised $250 million through a bond maturing in 2020. At that time the company was rated BBB, which is investment grade, but after well-publicised problems late in the year, Standard & Poor’s cut the rating to BB+ in December 2013. Moody’s followed suit in January 2014.

A sub-investment grade rated company that was not so familiar would almost certainly not have been as successful in raising funds. However, local investors seem to have formed a view that Qantas’ cash reserves, plus the fact that it has strategic options for dealing with its financial problems, make it a relatively ‘safe’ play outside the usual AAA to BBB credit range.

Of course, investors have only done this because Qantas paid a high yield. The 8 year deal done in May 2014 paid investors 7.96%, at a premium over the Government bond rate of just over 4.0%. The range of yields on other similar maturity bonds in the market at the time was more like 4.25 – 5.25%.

Risk and return

High yields are precisely the point to investing in the sub-investment grade space. High yields compensate investors for higher risk.

Mostly, this is a higher risk of default. Based on historical outcomes, bonds rated in the BB range are about ten times more likely to default at some point over the next ten years than the average investment grade securities (A to BBB ratings). See here for a more detailed discussion of credit risk and the meaning of high yield risk. There is also a liquidity premium to high yield securities compared with investment grade bonds.

However, the high yield market usually overpays for these risks and thus delivers very competitive return outcomes, against both shares and bonds (this analysis uses the Bank of America Merrill Lynch BB/B index hedged to A$ to June 2014. That is, the comparison is not based on a handful of domestic bonds, but the well-established US market). Over the long run of 25 years, high yield has returned 11% per annum, compared with 9.5% for Australian shares and 8.8% for Australian bonds. It has done this with 8% pa volatility, which is more than bonds (4%), but much lower risk than shares (17%).

Over the medium term of five years, high yield also compares very favourably. The return from June 2009 to 2014 was 15.9% pa. Volatility was 14%, which is higher than over the long run. Bonds have delivered 6.9% pa, but at lower than long run volatility (3%), while shares have returned 11.2% pa at about the same as their long run volatility.

The medium term comparison is fascinating. The five years to June 2014 commences just after the bottom of the GFC-induced blow-out in credit spreads and fall in share prices. Of course, the sharemarket has rebounded nicely since the GFC, but few would investors would realise that high yield bonds over the same period have provided almost 5% per year better return than shares.

So why is it called ‘junk’?

Given risk and return outcomes, it is unfair to call the asset class ‘junk’. That term came into being nearly 100 years ago when the high yield market was comprised entirely of companies who had previously been rated more highly, but which had encountered financial difficulties and become more risky as a result. These ‘fallen angels’ did not deliberately run their businesses to be BB or B credit rated, and issuing bonds with such ratings was problematic. They became, in the eyes of investors who had previously bought their debt, ‘junk’. Some would say that Qantas is a perfect example of such a fallen angel.

However, the modern high yield market is different. Since the 1980’s it has become a means by which particular kinds of businesses have been able to tap the capital markets for funding that might not have otherwise been available. Some people argue that the high yield market democratised capital markets, because banks, insurance companies and pension funds had previously spurned such issuers unfairly.

Therefore, nowadays the high yield market is mainly populated by companies who deliberately run their businesses as BB or B rated. They either have reasonably stable earnings but operate with high leverage ratios, or they have more conservative leverage in a highly volatile industry. They operate in industries not typically found in the investment grade space, and thus offer a more diverse universe of credits. The US market comprises around 1,500 sub-investment grade issuers and is valued at US$1.3 trillion.

Manage the risk properly

That said, each individual high yield bond does carry a relatively high risk of default. The only effective way to manage a credit risk portfolio is through continuous credit research and an appropriate level of diversification. The higher the credit risk of individual investments, the smaller the exposures to each company should be and the larger the number of individual holdings required. In high yield, we’re talking at least 50-100 holdings, if not more. Further, these should be spread across as many industries as possible in order to make sure you don’t have a concentration of risks.

Investors need to be cautioned against simply buying some Qantas bonds, along with a handful of the other high yield bonds that are available to retail investors in Australia, and believing that they have a healthy portfolio. The concentration of holdings makes that approach highly risky.

This is a space where managed funds or ETF’s really come into their own as an efficient way of getting the diversity that is needed.

Many investors are unnecessarily put off by the colloquialism ‘junk’ and don’t appreciate the case that exists for high yield bonds to be included in their portfolio. A well-managed portfolio of ‘junk bonds’ is not a junk portfolio. It can be a high-returning, moderate risk asset class.

 

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management. His roles now include consulting, serving as an External Member of the GESB Board Investment Committee and writing on fixed interest. His advice is general in nature and readers should seek their own professional advice before making any financial decisions.

 

RELATED ARTICLES

It's not high return/risk equities versus low return/risk bonds

High yield downturn will be long and ugly

Defaults low but no room for complacency

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Latest Updates

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Economy

Australia's economic report card heading into the polls

Our economy grew by a nominal rate of 7% per annum from 2017 to 2024, but it benefited from the largesse of fiscal and monetary policies, both of which are now fading. We need a new, credible economic growth agenda.

Preference votes matter

If the recent polls are anything to go by, we are headed for a hung parliament at the upcoming federal election. So more than ever, Australians need to give serious consideration to their preference votes.

SMSF strategies

Meg on SMSFs: Tips for the last member standing

It’s common for people as they age to seek more help in running their SMSF if their capacity declines. An alternate director may be a great solution for someone just planning for short-term help in the meantime.

Wilson Asset Management on markets and its new income fund

In this interview, Matthew Haupt from Wilson Asset Management discusses his outloook for the ASX, sectors such as REITs that he likes, and his firm's launch of a new income-oriented listed investment company.  

Planning

‘Life expectancy’ – and why I don’t like the expression

Life expectancy isn't just a number - it's a concept that changes with survival rates over time. This article breaks down how age, survival, and societal factors shape our understanding of life expectancy, especially post-Covid. 

The shine is back on gold, and gold miners

Gold mining stocks outperformed in 2024 and are expected to do well in 2025. At this point in the rally, it's worth considering what has driven gold prices higher and why miners could still have some catching up to do.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.