The recent weeks, Challenger’s Ltd [ASX:CGF] bond portfolio has come under scrutiny. In a world of low yield, Australia’s largest provider of retirement annuities has turned to risker assets to increase profitability.
Of Challenger’s $10.4 billion bond portfolio, around 24% are junk bonds.
Source: The Australian
For those who need a bond refresher, junk bonds are anything below a BB rating. They are the opposite to their AAA cousins, those considered to be the safest of the safe.
These ratings are given out by rating agencies based on cash flow positions. If a bond issuer can easily meet bond obligations and the future is bright, their bonds likely have a triple AAA rating.
The issuers that have cash flow problems and are struggling to meet obligations might receive a BB rating for their bonds. So why would anyone buy these junk bonds?
While they’re risker, they offer higher yields than AAA bonds.
Is the Extra Yield Worth the Risks Involved?
According to The Australian it’s not just Challenger bulking up on junk.
‘Insurance Australia Group, Suncorp and QBE have been bulking up on riskier financial investments over the past two years, partly to diversify the groups’ fixed income holdings away from major Australian companies. Profits in the insurance sector are under sustained pressure as premium prices flat line and natural disasters spark large claims blowouts.
‘Insurers derive a large part of their profitability from investment income and must find investments with yields high enough to support the company and pay claims, while at the same time tempering risk in order not to jeopardise their financial position.
‘With global interest rates at record lows, high yields are mostly found in riskier investments, and insurers have had to look towards bonds with lower credit ratings, including non-investment-grade assets known as junk bonds that pay a higher rate of interest.’
Source: The Australian
While all junk bonds don’t necessarily default, it’s concerning when billion dollar insurers are all bulking up on these assets. If a small portion of these bond holdings do default, companies like Challenger and Suncorp might be lucky to receive 50 cents on the dollar.
And if interest rates do rise, the situation could get far worse for those holding junk bonds. Therefore you might want to be cautious of Aussie insurers, as their portfolios remain heavy on junk.
But it’s not just insurers. Find out which other ASX stocks could be at risk of dramatic falls in the coming months by clicking here.
Junior Analyst, Markets & Money