There is value in emphasising the higher quality end of the high-yield market but it is important for investors to examine what is under the bonnet and take risk only where they are prepared to
We live in interesting times: imagine that the 2001 version of you travelled forward in time to today. Once you had stopped marvelling at everyone’s iPhones and focused on the important matter of fixed income securities, you would probably think that the definition of ‘high’ in high yield bonds was being somewhat stretched.
Higher quality high yield
Yields are at record lows – we all take this for granted by now, but it is absolutely central. The main talking point is usually how investors have been forced to move down the credit spectrum. That is true, but low yields do not have to be a negative. The ability to inexpensively refinance has helped keep corporate balance sheets healthy and default rates low, especially considering how long they have lived with this current lack of economic growth.
Although yields are low, spreads (which represent the difference in yield over the risk-free rate) are actually around their historical average. This means that – relative to other parts of the fixed income universe – high yield bonds do not look that expensive. There is still value to be found and a good deal more quality too. For example, the average credit rating of issues in my fund’s benchmark has improved from B+ five years ago to BB- today. This is in contrast to the investment grade index, which has seen its average credit rating fall from high single-A to A-/BBB+ over the same period.
Looking under the bonnet
It has been demonstrated that allocating part of a multi-asset portfolio to high yield bonds brings diversification benefits that improve risk-adjusted returns. So I won’t try to convince you whether you should invest in high yield, but instead focus on where you might invest.
It is tempting to think of high yield as a homogenous asset class, but look a little deeper and you will find significant nuances that will dramatically alter risk/return profiles. I think it is vital that investors look under the bonnet of their high yield funds to make sure they understand where performance has come from and what the risk implications are.
The high yield market includes bonds rated BB and below. In reality, however, it helps to think of the universe in two parts: BB-Bs and CCCs. The reason for this is that CCC rated bonds are a very different beast, with an historic rate of default that is not just a little higher, but dramatically so (see chart).
This is a relevant point because a lot of high yield funds have significant amounts invested in this highest risk part of the sector – data from Morningstar suggests that several funds in the IMA £ High Yield sector had over 15 per cent invested in bonds rated CCC or lower as at 31 March 2013.
The fund I manage – the Legal & General High Income Trust – deliberately excludes CCCs and financials because we want to offer a solution for those investors seeking a less volatile return profile.
During a credit bull market such as we have seen recently, funds that take a higher risk approach such as those investing heavily into CCCs have been rewarded, but of course that trend can reverse sharply. That is why it is especially important for investors to be aware of the ways in which their funds have generated returns, because as we all know it is hard to call the future of bond markets – and economies – right now.
Wild card: QE and ‘tapering’ in the US
One of the key areas of uncertainty recently has been the prospect of the US Federal Reserve slowing the rate of its quantitative easing stimulus, a process dubbed ‘tapering’. Note that this does not involve reversing previous asset purchases, but simply purchasing less in future. Even so, tapering has made the market nervous as investors have become somewhat addicted to the perceived impacts of QE.
Although the US is currently ahead of Europe and the UK in its recovery, our view is that a start to tapering becomes more likely from December onwards, by which time we anticipate US economic growth and inflation will have picked up further.
The assumption is that tapering would be bad news for bond investors because yields would start to rise (and we would certainly expect volatility to increase), but remember that the Fed would only start tapering when the US economy is on a path to sustainable growth. An end to this global economic slump is in everyone’s long term interests, however, regardless of their nationality or their asset class of choice. High yield, for instance, tends to perform well in a positive economic growth environment – in this way the asset class is more like equities than government bonds.
As a fund manager, all I can do is try to position my portfolio to make the most of the opportunities that are out there. I’m convinced there is value in taking an approach that emphasises the higher quality end of the high yield market, but whatever your chosen philosophy it is important you invest with your eyes open, taking risk only where you are prepared to.
Martin Reeves is the head of global high yield, Legal & General Investment Management