All hail the new puritans

Manager of the Kames Capital High Yield Bond fund Philip Milburn says the savage sell-off in bonds was a much-needed ‘dose of sanity’ and he welcomes a leaner, healthier market


The date 22 May is now etched on fund manager’s memories. It was the day when Federal Reserve chairman Ben Bernanke failed to rebuff a suggestion during congressional testimony that the central bank could begin tapering back bond purchases in September. Markets took it as a signal that the candy bowl was being taken away from the party, and equities and bonds promptly went into tailspin.  

The FTSE 100 has dropped by 12 per cent since then, while the impact on the bond market has been if anything more savage. Yields on 10 year gilts have shot up from 2.2 per cent to 3 per cent, while in the high yield market they have shot out from about 5 per cent to 7 per cent.

Bond funds that were enjoying strong year-to-date returns have u-turned, with many now showing a negative for the year.

But for Philip Milburn, manager of the £1.5bn Kames Capital High Yield Bond fund, it was a much-needed dose of sanity, even if his portfolio is showing a -1 per cent total return for the year.  

He says: “We have seen the past few years a lot of money chasing yield. The market has been a lot less disciplined, with covenants and protections not looking very good. We have been saying ‘yes’ to only one in every three or four new issues.

“22 May was when the Fed effectively said good luck with that guys. We have seen a savage sell-off. But now it means that high yield bonds have gone from fully valued to just about cheap or fair value.”

Unfortunately, being in the quality end of high yield has not been a good hiding place. BB grade bonds have suffered worse than the CCCs because in the sell-off, investors have junked what they can actually sell – and BBs are much more liquid than triple Cs. Much of the money flooding out of bonds has come out of the giant US exchange traded funds funds.

“They sold what they can, which generally has been higher quality,” says Milburn. The 3 per cent yield on the fund so far this year has been wiped out by a 4 per cent fall in capital,”

“But we think it has been a relatively healthy correction,” he says. Various factors give him confidence that now is the time to go back into high yield, even though retail sentiment to bonds has been dealt a severe blow.


Jason Hollands of BestInvest sums up what many advisers think about bond funds at the moment. He says: “We have been warning for some time that, largely as a result of the distortions created by central bank bond-buying programmes, fixed income would eventually face a day of reckoning once markets began to factor in an end to quantitative easing. In recent weeks this has begun to come home to roost and spreads have widened significantly.” He sees high yield bonds as less sensitive though not entirely immune.

But Milburn thinks that current spreads have now moved in line with the cycle average, and that investors in high yield are being adequately compensated for the risk of default. The highest level of defaults over a five year period has been 40 per cent, and that is now in the price of high yield. And the total yield, just shy of 7 per cent, is “not a bad figure to be looking at,” he says.

About half the fund is in dollar high yield, hedged back to sterling, representing Milburn’s confidence in the deepest and most liquid high yield market in the world. The total value of US high yield is $1.4trn, compared with €300bn in Europe. The UK market is relatively small and illiquid.

There are about 3,000 bonds in the high yield sector, and Milburn screens this down to about 110 for his portfolio, calling that ‘concentrated’ although an equity manager would not see it that way. Generally he regards highly cyclical companies such as autos and airlines as “not really suitable for a bond portfolio” so they are screened out straight away. Where he is overweight is in healthcare and telcos.

The turnover figure comes as a surprise – about 100 per cent a year. Bond departments are not as sleepy as some might think. But Milburn says most trading activity is concentrated in just 20 per cent of the fund.

It was in 2011 that this fund came to advisers attention, as one of the very few to make a positive return, helped by its US bias. But 2012 was less impressive, as it failed to take part in the rally in peripheral European markets.

An indication of how far Milburn is confident on high yield right now is that cash holdings, which went to a high of 17 per cent in the immediate post-Lehman crisis, are now at zero. “Over the past few weeks we have been buying back in to the market, although that may have been a little premature,” he says.

His biggest holding is in Matterhorn, the issuing name for the bonds of Orange Switzerland. He acknowledges that Apax, the private equity sponsor, has been relatively aggressive in extracting dividends but is confident that the company will soon return to the deleveraging path.

How sure is he that income investors in this fund can carry on picking up 6 per cent  yields? The fund is on the panel of Nationwide building society, so Milburn gets asked this a lot. Until 12 months ago, he was sure of 0.5 per cent a month, 6 per cent a year, in yield, but it drifted down to 0.42 per cent a month, or about 5 per cent a year.

And this year? He is quietly confident that it will drift back up towards that 6 per cent figure, even if not quite hitting it.


Patrick Collinson is the Guardian ’s personal finance editor