This article is authored by MOI Global instructor Saurabh Sud, Portfolio Manager at T. Rowe Price, based in Baltimore, Maryland.

As credit investors, we recognize that corporate bonds and preferred equity shares, bought at around par, offer inherently different payoff profiles to those available from ordinary shares. While common equity investors can hope to earn two-times or three-times or more on their investment, the only advantage of investing corporate bonds or preferred equity is the income yield – and it comes with the risk of losing a substantial part of the principal.

The good news is that the downside risk of credit investing can be mitigated by adopting either a high-quality focused strategy or an asymmetric profile-focused strategy. The challenge for a credit investor is to strike the right balance between the two and a good research platform can help navigate that.

A defensive credit investor may focus on high-quality companies with a wide business ‘moat’ (i.e., a substantial competitive advantage over their competitors) that have strong asset and cash flow coverage, and management teams with solid capital allocation track-records. A challenge with this approach is that the rest of the credit market is likely to be looking for the same types of businesses. This, combined with the fact that cash flows are contractual and defined for corporate bonds, mean that it is more difficult for credit investors to differentiate themselves than equity investors.

For example, HCA Healthcare’s stock has generated compounded investor returns of ~21.9% annually since 2011 (at which rate it would take 3.5 years to double the initial investment). However, HCA’s 5.625% 2028 unsecured corporate bond currently yields around 5.75% (at which rate it would take around 12.5 years to double the initial outlay – which is the best return possible from holding the security until maturity).

Through our Global Fundamental Research Platform, we at T Rowe Price can find many high-quality ideas that are differentiated from those of the market. However, another challenge of focusing solely on high quality companies is that near-term returns are likely to be dominated by macro factors such as interest-rates rather than fundamentals, especially for longer-dated corporate bonds that are bought near par.

Thus, to make truly exceptional equity-like returns in credit markets, a credit investor therefore needs to be very patient – in other words, to be what Benjamin Graham defines in his seminal book The Intelligent Investor as an ‘enterprising investor’. Paraphrasing Graham, an enterprising investor is one focused on asymmetric payoffs who is willing to put in the analytical work that is required to achieve them, thereby mitigating downside risks. And while Graham did not believe in market timing, he gave important clues about the market’s opportunity set and his definition of bargain prices for high-yield bonds and preferred securities. He writes:

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This material has been prepared for investment professionals only and should not be relied upon by retail investors. The specific securities identified and described above are shown for illustrative purposes only and do not necessarily represent securities purchased or sold by T. Rowe Price. All figures are US Dollars. This information is not intended to be a recommendation to take any particular investment action and is subject to change. No assumptions should be made that the securities identified and discussed above were or will be profitable. This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. investors may get back less than the amount invested. The material has not been reviewed by any regulatory authority in any jurisdiction. Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources accuracy or completeness. There is no guarantee that any forecasts made will come to pass. This material has been prepared for informational purposes only. The views and opinions stated in this commentary are those of the portfolio managers listed as of the date indicated. These views and opinions are subject to change based on market or other conditions and may differ from those of other T. Rowe Price associates. Actual market and investment results may differ materially from expectations. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price. The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

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