Managers believe that high-yield bonds still offer up plenty of opportunities, writes Maha Khan Phillips
Investors continue to pile assets into the high-yield bond market, and it is fairly easy to see why: it has been one of the best performing asset classes over the past five years, returning 22% annualised between December 2008 and the end of 2012, outperforming even emerging market equities. In 2012, European high-yield bonds returned 28.6%, according to Russell Investments, which points out that the Europe market is rapidly expanding and deepening in its industry and issuer diversification.
Euro-domiciled high-yield bond issuance has already topped €50bn this year, exceeding its former full-year peak, set in 2010. Across EMEA, high-yield issuance hit its highest volume in the year to September, at more than 253 deals, according to Dealogic. And there is plenty more to come. The euro market accounts for just 15.6% of the global market, also according to Dealogic. More issuers are coming to the market, and recent market volatility has generated opportunities for investors.
“As the European high-yield bond market expands and matures, we believe there will be an increasing number of attractive issuers whose bonds trade at elevated yields and whose credit quality is backed by high quality assets and or stable or contracted revenues,” says Michael Phelps, head of credit enhanced strategies Europe at BlackRock.
Most managers agree that high-yield is now fairly valued, despite producing lower returns than traditionally available. Europe’s high-yield market now trades at spread levels almost twice as wide as the record low of 250 basis points over Treasuries, set in 2007, and 150 basis points cheaper than the levels one would normally see when the default rate is at 2% or below, as it is today.
“Investors, including ourselves, have been almost spoilt by volatility, and such good rallies from the third quarter of 2009 to 2012, when we have seen double-digit returns,” says Phil Milburn, fixed income fund manager at Kames Capital. “Now we are looking at high single digits, 5% or 6% or 7% returns, for the asset class.”
Milburn says he prefers the US market at the moment, because it is yielding roughly 150 basis points more than Europe’s. “But it comes with a bit of a health warning in that two-thirds of that additional yield is due to Treasuries yielding more than Bunds, [although] US spreads are [still] a little wider than European ones.”
Meanwhile, much investment-grade paper trades at spreads where a modest rise in interest rates could wipe out a year’s worth of coupons. Of course, a lot depends on the macro environment. September’s announcement by Ben Bernanke that there would be no ‘tapering’ of quantitative easing took the market by surprise.
“We are still always subject to rates backing up again,” says Paul Appleby, head of leveraged finance group at Pramerica, which has recently joined the flood of managers launching ‘short-duration’ funds to meet investors’ desire for interest rate protection and less volatility. “The surprise move by the Fed was followed by a big rally. This movie can be played again and again six months from now. You can get happy about it but the reality is that, at some point, you want the economy to recover. The Fed has just delayed the inevitable.”
Chris Redmond, global head of fixed income manager research at Towers Watson, cites this as one reason why his firm favours high-yield bonds over investment grade.
“If I picked up my standard high-yield bond fund and I get a yield of 6%, then 5% of that is compensation for credit risk and 1% is due to interest risk,” he says. “The majority of the return is made up of the credit component. If I move into the investment grade space, which is closer to a 3.5% absolute yield, that comprises of 150 basis points of credit risk and 2% from assuming fixed interest rate risk. So the total return of investment grade credit will be driven predominately by movements in the perceived risk-free rate. It provides another layer of complexity.”
However, Milburn at Kames believes that, on a duration-neutral basis, investment-grade debt is more appealing than high-yield.
“We continue to like the risk return in investment grade, provided you can hedge out some of the duration,” he says. “The structural sell-off is already in the price, with Treasuries having bottomed at 1.6% and now yielding 2.5%, but we still want to be underweight interest rate risk.”
Within high yield, while a lot of firms have been launching ‘short-duration’ portfolios, Milburn actually suggests that the ‘sweet spot’ is the five-to-seven-year range.
“Anything less than five years tends to be trading quite expensively, and anything longer than seven years and the bonds have reasonable duration sensitivity,” he reasons.
He also prefers the single-B part of the market. “We think at CCC you aren’t being adequately compensated for the risk you are taking,” he says. “BB is the highest quality and the spread in comparison to total yield is lower. So our favourite part of the market is single-B, where we are talking about reasonable yield but little duration.”
But Rupert Watson, head of asset allocation in Mercer’s global fiduciary business, notes that the attractiveness of high-yield might depend on the reasons why you are looking at the asset class in the first place.
“We retain a broadly positive view on high-yield and think it will perform relatively well, but equities will be the best asset class, supported by recovering profits, low interest rates, and low inflation,” he says.
In other words, if you have edged – or are thinking of edging – into high-yield in your fixed-income portfolio, to find some spread and limit interest rate sensitivity, it is probably worth sticking with the plan. But if you moved there to take some of the volatility and downside risk out of your growth portfolio, now might be the time to think about rotating back into equities.