Higher rates and rising inflation have resulted in a dramatic turnaround – and perception – for fixed income in the past 18 months.
In a volatile and uncertain market such as this, a yield of more than 5% from a UK 2 year gilt is not to be sniffed at, while UK corporate bonds have garnered attention given their attractive income, lower risk, and attractive value (the average price of a bond in the sterling corporate bond market today is 87p in the pound as many were issued during the era of quantitative easing). But there is one area of the market, which is still being overlooked – high yield bonds.
I’m sure many of you would be quick to say, “why would I need to take the additional risk when I can get such good yields on government or investment grade bonds?”. There is validity to that question – but there is also an argument that the perception of this segment of the market is wrong.
See also: Are US equities overvalued, or are valuations just high?
Supporters of high yield would say it actually sits between equities and fixed income. The latter (the likes of government and investment grade bonds) are almost a stabiliser, which offer – as the name suggests – income to the investor. The high yield proposition to investors is more that we take some capital, we expose it to some credit risk and then we invest into some exciting companies. I’d also argue that an average yield of 8.5% for a bond in this space is not to be sniffed at.
Figures from Bloomberg show that when this segment yields between 8-10%, it usually results in positive returns for global high yield bonds over the next 12 months (61% of the time returns have been in excess of 10%).
Positives, but the threat of recession still looms large
While there are attractive yields and potentially strong returns on the horizon, the fear is that we’ve had a lag effect from the impact of monetary policy. Jupiter investment manager, fixed income, Adam Darling says the huge amount of monetary tightening by the central banks over the last 12 months is only now hitting consumers and businesses and we’re likely to have a recession.
The big question is the potential for defaults. Moody’s has estimated that the default rate for global high yield bonds could hit almost 5% in 2024, as higher borrowing costs and tighter lending standards add pressure to the market. However, there are a few factors that indicate any pending recession may not be a case of history repeating for defaults.
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Artemis Global High Yield bond co-manager David Ennett says there may be a recency bias towards the last couple of recessions which could be affecting the high yield market. He says the market has become accustomed to fast/painful recessions and forgotten about plain vanilla/milder Fed induced recessions – designed to stop economies overheating.
Jupiter’s Adam Darling says he has been surprised at how well the high yield market has held up in an environment where banks have dialled back on risk appetite, making it harder for companies and consumers to access credit – adding that historically this would lead to credit spread selling-off, which has not been the case on this occasion.
Part of the problem could be down to the structure of the high yield bond market. Some still see it as the Wild West. It’s not quite the gunfight at the O.K Corral, but many feel it is still fraught with risk. The reality is that while there is still some risk, the sector has matured markedly.
For example, the highest quality high yield bonds (BB) now account for 58% of the market (it was only 40% at the start of 2008); by contrast the proportion of CCC’s – the riskiest part of the market – has halved from 17% to 9%. To put this into context, research from S&P found that between 1981-2021 the average chance each year of a default for CCC bonds was around 25%, while for BB it was just 0.6%.
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T. Rowe Price Global High Yield co-portfolio manager Mike Della Vedova says company balance sheets in the sector remain in good nick – with cash ratios strong and leverage ratios relatively low – all of which should keep defaults low for the rest of this year. He also believes many high yield companies took advantage of attractive conditions in 2020-21, pushing their maturities to 2025 and beyond; meanwhile fewer companies will come to the market, creating stronger demand.
More volatility and selected opportunities
With stubbornly high inflation, slowing economic growth, and banking sector concerns – volatility remains the order of the day. This will bring dispersion and opportunities for active managers investing in high yield bonds.
Artemis’ David Ennett says at 3% of the global high yield market, the UK is currently looking attractive, while Jupiter’s Adam Darling says Latin America has some hard currency bonds, issued by relatively solid businesses, which are being offered today at valuations already consistent with a recessionary environment. By contrast, many are wary of the highly levered cyclicals side of the market, preferring the likes of healthcare and consumer staples.
With dispersion in returns likely to grow, a good example of an experienced stock picker in this market is Man GLG High Yield Opportunities manager Mike Scott. An alternative is the Artemis Global High Yield fund, where the managers focus further down the global high yield index to consistently find hidden gems with a strong upside, helping them to outperform.
Meanwhile, those who want a more diversified approach might consider the Jupiter Strategic Bond or the Nomura Global Dynamic Bond fund, both of which have significant high yield exposure.
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PA EVENT: Fixed Income, September 14th | RSVP HERE
Hosted at Pan Pacific Hotel
Join us for an in-depth exploration of the fixed-income market, where industry experts will delve into the current landscape, emerging opportunities, and strategies for optimizing fixed-income portfolios.
Sponsors include Alliance Bernstein, J Safra Sarasin, Premier Miton, RBC Bluebay, Vontobel and 1 more to be announced.
