However, long before I became involved as a partner at High Rock, I was helping families build balanced and diversified portfolios and came to the realization that in a low return environment, this particular asset class could add an excellent stream of income and also (if the portfolio of high yield securities is well managed) be an important source of strong risk-adjusted returns.
Why does it need to be well managed?
High Yield, by definition means that the debt rating agencies have rated these issues as lower than "investment grade", BB or lower (in the cast of most rating agencies), likely because there is increased risk associated with the particular company who has issued the bonds. In turn, the increased risk means that investors want higher yields as protection.
As a result, there is plenty of expertise and due diligence that is required:
- Understanding the complexity of the covenants of the securities (capable of reading through the legal document or indenture).
- Regular monitoring of financial reports and developments within the companies.
- Knowing when the risk profile changes (having an ear to the market) and requires an adjustment of the holdings (selling companies that present potential problems).
- It is also important to know how to best execute the trades in the "over-the-counter" (OTC) market.
- Proper diversification across many issuers (industry sectors) to ensure that one problem company will not significantly impact the total portfolio of holdings.
Also, most of these issues are not available to individual (non-accredited) investors and are only available in a fund format.
Also important, this is an asset class that is not necessarily interest rate sensitive and when interest rates start to rise, it is because the economy is strong and that is favourable for the High Yield sector.
A strong economy will mean growth opportunities and the greater potential for a rating upgrade that can offer potential capital appreciation.
All in all, sound arguments for further diversifying a portfolio with Canadian High Yield bonds.