M&G’s Stefan Isaacs believes the healthy correction in bonds has removed the froth and brought back pricing in line with economic fundamentals, with value re-emerging
Value is re-emerging in bonds, says M&G’s Stefan Isaacs. Fund managers can be almost guaranteed to say that when markets fall, it means assets are now better value. But six weeks into the bond bear market, if that’s what it is, M&G is confident that in high yield at least, there’s reason for optimism.
“It has been a healthy correction which has removed the froth,” says Isaacs, who manages the M&G High Yield Corporate Bond fund, which has £1.3bn under management. “It has brought back the pricing of bond yields more in line with economic fundamentals. We have also seen the winding down of the carry trade, which has led to value re-emerging in this space.”
For reasons Isaacs says he doesn’t quite understand, high yield as an asset class seems to lack credibility. Yet he points to graphs which show that, over 25 years, high yield has on average earned a return of 9 per cent a year compared with 6 per cent a year for FTSE 100 and with lower average volatility. Interestingly, gold has been about the worst asset class to be in over the past quarter century, despite its massive bull run until this year’s reverses.
Isaacs isn’t just talking his own book. In M&G’s giant £15.6bn Optimal Income fund, manager Richard Woolnough has also increased his holdings in high yield from 23 per cent to about 30 per cent.
Most of what Isaacs invests in are industrials, which make up about two-thirds of the fund. Issuance in euros has trebled in the last five years as the banking crisis has seen industrial companies seeking finance elsewhere. It means the market is more diverse and liquid, and less dependent on bonds issued by banks.
“It has allowed us to better differentiate between companies, sectors and ratings. We are no longer forced into certain sectors such as tech,” says Isaacs.
The bond market blow-up of 1994 holds important lessons for today, says Isaacs. Although high yield emerged far from unscathed, in 1995 it outperformed strongly. “High yield has traditionally been the place to be in times of rising bond yields,” he says, although none of us can be really sure about how much yields are really going to rise. It’s interesting that US inflation has been falling, despite the mild recovery in the US economy. As Jim Leaviss, head of fixed interest at M&G notes, it is impossible to hike rates in the US if inflation is not a problem.
One comfort to investors fearful of low-quality ‘junk’ bonds is that default rates have come in nowhere near as high as the market was forecasting in the dark days of 2008/09. Almost everything was priced for default then; now we are back to expectations of fairly ‘normal’ rates of default, which themselves may be overly bearish considering that we are coming out of the recession, albeit slowly.
But don’t look at things too simplistically, warns Isaacs. He points out that corporate net leverage has actually been deteriorating, which is remarkable given that just a few years back we were staring at economic armageddon. Companies have not been stupid; they have been borrowing at record low interest rates and passing the money back to shareholders. Fine for shareholders, but not for holders of the debt.
“The deleveraging of 2008-10 has clearly run its course and we are now in a re-leveraging trend,” says Isaacs, although he says it’s a trend that is apparent only in the US, not in sclerotic European economies. “The degree of confidence among European corporates is still very limited.”
And that is the main reason why Isaacs prefers European high yield to American. “As an investor, my alignment is with companies that are behaving in a conservative fashion, although we are very conscious of earnings. Going forward, we expect to see continued bond-friendly behaviour in European high yield rather than American high yield.”
Should we not be worried about a higher potential default rate in Europe than America? Possibly, says Isaacs, but he points out that the market has been able to refinance maturing bonds quite easily, and pushed out worries about a ‘maturity wall’. “That argues for a continued low level of defaults,” he forecasts.
He likes single-B bonds most, and emerging markets least. About 25 per cent is in the US, 20 per cent in the UK and 15 per cent in Germany. Very little is in Southern Europe, although he reckons some situations there are beginning to look very interesting. The big underweights are banks, but French autos get a special mention – for being both rubbish cars and rubbish bonds. He’d rather be overweight in pharmaceuticals and capital goods.
Performance on the fund has been middling to good. It is second quartile over one year in the IMA £ High Yield sector, with a gain of 10.8 per cent, although year-to-date the the fund is showing a gain close to zero. Over three years it is almost exactly average, earning a return of 25 per cent.
2012 was an epic year for high yield, giving investors about 25-27 per cent. Isaacs says there is virtually no chance that will be repeated in 2013 or 2014, especially given the losses in May and June. But amid all the wider fears of a bond market meltdown, he’s relatively sanguine, although he warns investors that they better get used to earning their returns from income, not capital.
Patrick Collinson is the Guardian’s personal finance editor