Look beyond the yields of unlisted debt securities, says Morningstar

Morningstar today published a special report summarising the key issues and risks investors should consider before investing in unlisted debt securities.

Key Takeouts

–          Low interest rates, continuing demand for yield, and attractive headline returns are prompting many investors to invest in unlisted debt securities without fully investigating the accompanying risks and whether these risks are appropriate for their investment profile.

–          Investors considering investing in a debt security should undertake thorough due diligence to understand the security’s key characteristics and risks, including whether the return on offer is commensurate with those risks. As well as the debt security’s prospectus, investors should consult the issuer’s publicly-disclosed financial and business information such as annual reports and investor presentations, as well as independent research.

–          Investors should investigate where the bond sits in the capital structure; whether there are any covenants in the terms of the issue; whether the debt security is secured against any assets, and recovery prospects for those assets in a worst-case scenario; and whether the price of the debt security is cheap or expensive relative to comparable securities.

–          Investors should also consider the debt security’s yield to maturity, rather than running yield; any early redemption features at the issuer’s discretion; whether the security is fixed or floating rate, and how it is likely to behave in a rising or falling interest rate environment; and how multiple debt securities in the investor’s portfolio are correlated with one another and likely to behave in a market downturn.

–          Investors should also carefully assess a debt security’s credit risk, or ability to continue making income payments, before making an investment decision, and should continue to monitor that credit risk over time.

–         While investors may believe they intend to hold a debt security to maturity, they should always consider liquidity in both their initial investment decision and ongoing monitoring. An unexpected need for access to principal may not be able to be met if the debt security is illiquid.

–         Investors should generally look for debt securities which display a narrow bid/ask spread, are a larger issue size (smaller issues generally have lower liquidity), are issued by a publicly-listed company with continuous disclosure requirements (private companies’ bonds tend to be less liquid than those of publicly-listed companies), and are traded in a market with a market-maker (which provides liquidity by undertaking to buy and sell at specified prices at all times). The more of these features a debt security possesses, the better.

–          Investors should also demand full disclosure of fees and charges. The bond market commission and fee structure is significantly more opaque than is the case for the sharemarket. Key issues include the broker’s commission/fee structure; how commissions/fees are calculated; whether the yield to maturity figure being quoted is before or after commissions/fees; and whether the pricing is being provided by an independent dealer, and any relationship the dealer has with the issuer.

–          Investors should also consider managed funds and exchange-traded funds as an alternative to investing in a single debt security. These vehicles are generally diversified across issuers, security types, sectors, credit ratings, and other key characteristics, providing significantly greater diversification and risk minimisation than a single debt security. Any potential managed fund or ETF investment should be subjected to the same due diligence as for an unlisted debt security, including careful reading of independent investment research.

For more information contact  Nigel Crampton, Morningstar head of sales.