Within the latter part of the economic cycle, the default rate may increase. Among the many yield strategies, taking on additional credit risk is an important part of it. Historical experience has found that if investors are willing to give up some nominal “yield” in exchange for more protection from default scenarios. A secured high-yield bond deserves investor attention.
Senior secured bonds have capital structure advantages
Enterprises have different tiers for external financing. That is to say, if a company defaults and enters the bankruptcy process, the debt repayment will be based on the order of the capital structure. If the bond or loan has collateral, there is a corresponding asset as a guarantee. Senior bonds will be repaid in priority against sub-ordinate bonds.
Multiple assets can be used as collateral, including homes, machinery, automobiles or intangible assets. When a company defaults, the collateral can be sold and the debt of the company repaid. As senior secured bonds are prioritized in the capital structure, it is easier to recover the money sold.
Senior secured bond recovery rate is high
The recovery rate is the debt ratio that can be repaid or recovered once the company defaults. Its level will depend on a number of factors, including the nature of the collateral and the market conditions of the asset.
The characteristics of collateral for senior secured bonds make their recovery rate often higher than unsecured high-yield bonds. According to historical statistics, between 1987 and 2017, the average recovery rate of senior secured bonds was 62.3%, which was higher than unsecured and subordinated debt.
Recovery rate of different asset classes
Data Source: Barings; Moody’s
It is worth noting that Senior Secured high-yield bonds may not be able to provide volatility or provide risk protection for the down market. However, advanced mortgage high-yield bonds provide investors with more capital protection than traditional high-yield bonds.
Senior Secured bonds have market depth
Senior Secured bonds are not a new asset class. History dates back to the 1990s. Since the financial tsunami, Senior Secured bank loans have gradually been exchanged by Senior secured bonds, driving strong growth in this asset class. Currently, the total value of the market has exceeded $309 billion.
Secured is not a panacea. If investors do not have the appropriate knowledge and experience, they will not be able to distinguish between the pros and cons of collateral. More importantly, in the event of a default, experts are required to deal with litigation and other issues. Therefore, active management products with a long history can generate an extra return from selecting suitable items.