Today, however, the high yield market faces two major headwinds.
Reversal of fortune
Firstly, a cash-generative recovery is by no means guaranteed, which impacts the issuers’ ability to pay coupons and repay bond holders.
Secondly, despite the recent stumble, high yield performance has been exceptionally strong since the end of 2008, with the US high yield market returning 143% and the European equivalent gaining a phenomenal 159%, including coupon income.
The rapid appreciation has pushed the price of many high yield bonds above the value at which they will mature. Consequently, if investors move into the asset class at this stage of the cycle, they will be exposed to capital losses as their bonds approach maturity and also face significant call risk as high yield issuers attempt to refinance before interest rates do indeed rise.
The strong performance has also created a volatile investor base, with many investors needing little excuse to exit the high yield market and lock in what may be an unrepeatable level of performance.
Historic data confirms that the correlation between convertible and high yield debt weakens as interest rates rise, and – more importantly – that convertible bonds have typically outperformed high yield during periods of rising interest rates.
Short maturities mean that convertible bonds are less sensitive to changes in interest rates than traditional fixed income securities. In addition, the equity component of a convertible bond is likely to appreciate in an environment when central banks are tightening monetary policy. This is widely known and has been an important driver of recent flows into the convertible bond market.
Reason to triumph ?
The key question is whether convertible bonds can maintain the strong level of performance they have delivered year-to-date and how this asset class will fare against other duration-light securities, most notably high yield corporate debt.
Considering high yield debt is already looking expensive, the anticipation of rising interest rates implies that convertible bonds are likely to continue to outperform. By virtue of their corporate link, convertible bonds are also exposed to the economic recovery – without sharing the asymmetric risk profile associated with traditional fixed income at this point in the rates cycle, and hence able to benefit from an equity market upside.