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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