The challenges of direct bond investing for individuals and the importance of diversification and active management in a portfolio have come to the fore during the COVID-19 crisis. Simon Wang, Senior Credit Analyst at Daintree Capital, uses the recent example of Virgin Australia’s corporate bond to illustrate. He argues a well-managed portfolio of corporate bonds will create the intended diversification effects, compared to direct investment.
In this time of volatility and uncertainty due to the impact of COVID-19, many asset classes have been hurt badly from the lofty and tight valuations of pre-pandemic times. Companies that have benefited from investors’ hunt for yield in a low yield era, and a market flushed with central bank liquidity, are now facing liquidity problems, rating agency downgrades, and an inability to raise financing. Virgin Australia is one such example. In this environment it is apt to quote Warren Buffett; “Only when the tide goes out do you discover who’s been swimming naked”.
Virgin Australia: A case study
Virgin Australia Holdings Limited (Virgin) is Australia’s second largest airline. It launched in 2000 and listed on the Australian Stock Exchange (ASX) in 2003. As of first half fiscal 2019, it had generated revenues of $3 billion and carried around 26 million passengers.
As Australia’s response to COVID-19 escalated, Virgin reduced capacity and grounded its subsidiary Tiger Airways. Eventually, the airline requested financial support from the Australian Government in the order of $1.4billion as part of a broader industry support package. With no commitment from the government, Virgin announced it would enter voluntary administration to recapitalise the business to ensure it emerged in a stronger financial position.
The debt structure of Virgin included secured bank loans (secured by aircraft), unsecured loans, unsecured bonds (issued in AUD and USD), finance leases and letters of credit and bank guarantees. In 2019, Virgin also issued $325 million of five-year unsecured notes with a coupon of 8% and calls at 3 and 4 years, which were available to the retail market.
Ratings action – Understanding default risk
The ratings consider a bond issuer’s operational and financial strength and determine the credit quality and ability to pay a bond’s principal and interest. Credit metrics including leverage and interest coverage ratios are used, along with statistical distribution estimates of the probability of default and loss severity. The ratings are ranked from the highest credit quality of AAA down to CCC and D for default.
In January 2020, Virgin had a refreshed rating of B2/Stable for the corporate family and B3/Stable for the senior unsecured debt by Moody’s. The refreshed B2 rating placed the airline in the sub-investment grade band, having a significantly higher default rate compared to the typical investment grade bond issuers in Australia.
In March, once the implications of COVID-19 on the global economy were reflected in the market, Moody’s downgraded Virgin’s corporate family rating to B3, the backed senior unsecured rating from B3 to Caa1, and placed the outlook on review for downgrade.
It was a slippery slope from there, with Virgin announcing shares had been suspended from official quotation on the ASX, pending an announcement regarding its ongoing financial assistance and restructuring alternatives. Moody’s further downgraded Virgin’s corporate family rating and the senior unsecured rating, and left the outlook on review for downgrade in April.
Virgin entered voluntary administration on 21 April and it is expected that any steps taken to ensure the airline’s viability will result in economic loss to creditors, and in particular to unsecured creditors. Virgin’s current corporate family rating is Caa1 and unsecured rating is Caa3. This Caa3 rating means there is almost a 20% chance that Virgin will be downgraded to default1.
S&P have similarly downgraded Virgin with it rated at CCC for the issuer rating and C for the unsecured rating, while Fitch has Virgin rated at D.
Virgin’s corporate bonds have been trading at approximately $15/$16 post-administration announcement by distressed traders. This is a big haircut on the unsecured notes and bonds which have a par value of $100. For example, if someone were running an equally weighted bond portfolio of 10 names and this Virgin bond ends up recovering 30c on the dollar, they would have permanently lost 7% of their capital in about six months.
Importance of diversification
The detrimental loss of value of the Virgin bond is a good example of the need to diversify. The importance of diversification is to minimise losses from occurring in any one concentrated holding and to split the risk of drawdown across different assets. Diversification would allocate a smaller proportion of a portfolio to a specific bond and minimise the loss where an event, like COVID-19, shuts down specific sectors of the global economy.
Research shows that for a one or five-year period, the optimal portfolio of bonds, with correlated defaults, is a portfolio of between 50-100 corporate bonds. This optimal allocation does not significantly increase if the number of corporate bonds increases beyond 100 firms2.
The challenge for individual investors
Although Virgin bonds were available to the retail market, there are generally significant barriers to entry to the corporate bond market for individual retail investors. This lack of development of a quality corporate bond market for retail investors is a major failing of the Australian financial system. The few brokers who do specialise in fixed interest for retail clients charge exorbitant fees, which is significant when rates are low.
A common requirement to access bonds, under the Corporations Act, is the investor has to be a sophisticated investor (net assets of at least $2.5 million or gross income of $250,000 a year). The bonds available to the retail market are typically in smaller parcels, usually with a $50,000 minimum, have a higher return and risk, and are unrated by the ratings agencies. Another hurdle is that higher quality, well-known corporate names do not supply bonds to the retail market, are traded over-the-counter with brokers, and settled in Austraclear where the minimum parcel is $500,000.
To achieve the optimal level of diversification to minimise default risk, 50-100 bonds, investors would need approximately $25 million for 50 corporate bonds at the initial minimum position size. This is quite a sizeable amount for an individual investor, and simply unrealistic for most Australians.
What the Virgin example can teach investors
The Virgin bonds is an example of a deal performing badly for the bondholder. While it provided an attractive yield and accessibility to the retail market, it was issued based on sub-investment grade like metrics. It was also an Australian issuer with high yield for the institutional market.
This case highlights the challenges of direct bond investing for individuals, especially when considering higher credit quality risk, the hunt for yield, and the impact of a lack of diversification.
Investing with an active fixed income manager provides investors with access to the scale of a fund that can hold between 50 to 100 bonds, providing the proper diversification while also giving access to high quality issuers and securities that individuals cannot easily acquire.
1 Source: Moody’s Annual Default Study.
2 Wise, Mark B. and Bhansali, Vineer, Implications of Correlated Default for Portfolio Allocation to Corporate Bonds. California Inst. of Tech. Working Paper No. CALT-68-2405. Available at SSRN: https://ssrn.com/abstract=327840.
Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.