We have particularly liked strategic bond funds that can invest globally and across the credit spectrum while also managing their exposure to duration.
Outsource asset allocation
In essence we have been happy to outsource timing and allocation decisions to our preferred fixed income managers such as Richard Woolnough, manager of M&G Optimal Income.
However, given that many strategic bond managers have been steadily increasing their allocation to high yield we have recently taken a closer look at the asset class on a standalone basis.
High yield has been called ‘equity in drag’ so can it be considered an asset class in its own right? Over the past 26 years the total annualised return from high yield has been 9.6%, of which a surprising 10.6% has come from income. While this means that the capital has on average been eroded by 1% each year, the sustainability of coupons is much easier to predict and the income component is a major factor in the reduction of overall volatility.
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High yield has delivered equity-like returns with much lower volatility and while the correlation to equities is about 0.6 it is only 0.1 to government bonds and so can be a useful diversifier within portfolios.
Key to investing in high yield is the default rate. This has historically been about 4% per annum but in the past 12 months has been running at about 2%. This default rate is not expected to increase even if profit margins, which are currently at peak levels, fall. Balance sheet strength is much more pertinent to a bond investor than earnings growth and corporates have de-levered significantly over the past few years as evidenced by the fact that upgrades have outnumbered downgrades and improving interest coverage ratios.
Over the next two-and-a-half years only 5% of high yield bonds are maturing so refinancing risk is also low.
While high-yield has performed well in recent months we do not believe that it is too expensive given the attractive yield and the low default rate environment.
So how best to achieve exposure?
We like the Aviva Global High Yield Bond Fund. The team based predominantly in Chicago and London is experienced and well-resourced. They manage approximately $4.4bn – a reasonably modest amount compared to some of their peers – but they believe this to be an advantage in a capacity-constrained sector.
The team focuses on the higher quality end of the market with the majority of assets invested in companies rated BB or B. They only buy corporate debt domiciled in investment grade countries with a bankruptcy code of conduct. This more conservative approach means they have the ability to outperform in bear and sideways trending markets but will tend to underperform in bull markets.
Their average annual default rate is 1% versus the market’s rate of 4%. We believe this ‘winning by not losing’ approach is particularly suited to a bond fund manager and helps the high yield bond asset class fulfil its function of being a volatility dampener within portfolios.
While we are maintaining exposure to our preferred strategic bond funds we nevertheless feel that an allocation specifically to a high yield bond fund is appropriate and in our income, higher risk strategy we currently have a 7% weighting to the Aviva Global High Yield Bond fund.
