The high yield sector left other fixed interest assets and most equities trailing in its wake after delivering double-digit returns last year – so what does the future hold?
This asset class has benefited from the search for inflation-beating income yields, with investors finding little value in gilts and other ‘safe-havens’. The global high yield index produced a total return last year of 19%, in spite of threats such as the fiscal cliff and ongoing uncertainty in the eurozone.
Given the volatility of stock markets and low interest rate environment, it is easy to understand the attraction of riskier, higher yielding bonds. Along with equities, the sector has continued to rally into 2013, with surprisingly low defaults in a difficult climate as companies shore up their balance sheets to ride out economic turbulence.
Thomas Becket, chief investment officer at PSigma Investment Management, says: ‘Corporates are in good shape, with cash on their balance sheets, and they continue to pay down debt at a record pace, while sentiment for the high yield sector remains red hot.’
However, yields have been pushed to a historic low, says James Gledhill, global head of high yield at AXA Investment Management. At present, high yield bonds yield between 5% and 7%, making them attractive compared with other income-producing investments. Yet quantitative easing policies have been pushing up high-yield bond prices, and putting downward pressure on yields.
He adds: ‘On a relative basis versus government bonds, spreads remain pretty wide and defaults are far below average. Investors are being well paid for taking credit risk, and we are comfortable that default rates will not increase in the near-term.’
He believes that global high yield spreads remain appealing compared with government bonds. However, high yield bonds have yet to become detached from fundamentals, stresses Wes Sparks, head of US fixed income at Schroders, (pictured left) so performance will depend on events.
He says: ‘The question for the high yield asset class is whether there will continue to be sufficient positive forces to contribute to modest price appreciation in addition to the yield, or whether negative catalysts will emerge to drive price declines so that the realised return would be lower than the yield.’
However, the economic environment is making it difficult for a company to default. ‘With low interest rates, the cost of running a high debt burden is relatively low, and with a bond market hungry for issuance, many companies can term out their liabilities,’ says James Tomlins, manager of the M&G European High Yield Bond fund.
Low default rates have driven investors to retain or add to their high yield holdings, despite yields at record lows, and this trend looks set to continue. But will turning to the riskier debt in search of tempting gains prove wise going forwards, given the macro environment?
According to investment commentators, the overall market environment continues to support the high yield asset class, although the hefty returns of last year may not be achievable.
Sparks says: ‘As the year began, we forecast that the total return for the global high yield sector would likely be in the 7-7.5% range.
Focus on the technicals
‘With one-third of the year now complete, the year-to-date return is 4.72% through to April 30, so it is running ahead of that pace, with valuations continuing to be supported by solid underlying fundamentals.’ However, he adds that positive technicals have become the key driving force for the high yield bond market rally in recent months.
‘Strong demand has outpaced net new issuance, dealer inventories remain light, and finding sellers of large blocks of high yield bonds in secondary trading has been challenging. These technical factors have been the primary contributors to high yield spread tightening, along with extraordinary policy actions by many central banks which have reduced the risk of a systemic crisis,’ he says.
Central banks have used monetary policy to tackle economic difficulties, while their focus remains on trying to stimulate economic growth, with fiscal policy aimed at reducing government deficits.
Phil Milburn, fixed income fund manager at Kames, (pictured left) adds: ‘Technicals, the opposing forces of supply and demand, should never be underestimated in bond markets.
‘The huge of supply of leveraged finance, either in high yield bond or leveraged loan format, has been grabbing many headlines. Over the year to date, the high yield market has absorbed over $150 billion of issuance Stateside and more than €30 billion in Europe.
‘At the current run rate it will be the largest ever year of gross supply. However, it is worth noting that over half of the new issuance is merely refinancing existing debt, therefore the net supply number is significantly lower.’
Yet with an abundance of paper on offer, investment commentators are warning that the market could be flooded. Earlier this year, for example, Becket sold down his exposure to high yield credit. ‘Our view is that this asset class is looking distinctly dangerous and expensive,’ he says. He has expressed concerns that there could be a liquidity crisis, with huge amounts of money flowing into the sector.
‘A number of institutional investors and US mutual funds have been selling down exposure to high yield credit, which makes me nervous as, if there is a sudden rush for the exit, there could be liquidity problems for the funds,’ he says. ‘Also there is no margin for error in this sector, so if we see a resumption of the European crisis, serious issues in China, or a downturn in US economy, these will have an impact.’
On whether the market will suffer a bout of indigestion, Milburn adds: ‘This will only occur once investors’ cash balances have been whittled down to a level that creates discomfort, and remember that nowadays the investment banking trading community has so little of its balance sheet committed to trading bonds that there is only a minimal buffer for when the market turns in either direction.’
Meanwhile, Bryn Jones, head of fixed income at Rathbones, warns: ‘My concern is the growing leverage in high yield companies. As rates and spreads are low they are increasing leverage to take advantage of the low debt costs. They can do this as interest expense is low, but if rates rise and/or spreads widen, the next refinancing window could be tough.’
Where to invest
On where the opportunities lie to invest in high yield, Gledhill says: ‘When looking at allocations to the US and Europe there are many things to bear in mind, including valuations, liquidity and the macro environment, or headline risk, which has become a much more important consideration than it was in the years before the financial crisis.’
Considering the wider economic environment, the US is in better shape than Europe, with signs of returning to growth. ‘This improving picture means that we are beginning to see the return of risk taking in the US market,’ says Gledhill.
However, he adds: ‘Most European companies remain in a bunker mentality with a continued focus on strengthening balance sheets and remaining cautious. This means that defaults are less of a concern than you might expect as they are prepared for the difficult macro environment.
‘The average credit quality of the market in Europe is better than in the US. Although the two markets appear to yield about the same, when you adjust for the credit quality difference, European yields are around 80bps higher than in the US which seems fair.’
Milburn says he maintains a strong preference for North American and northern European-based corporations. ‘Southern Europe is imposing self-defeating austerity on its economies,’ he adds.
Tomlins says: ‘The dynamic affecting European high yield is one of two opposing forces; on the one hand the poor fundamental performance of the European economy, which impacts many of the underlying companies that issue high yield bonds, and, on the other hand, the cumulative impact of injections of fresh liquidity into the global financial system from central banks.’
However, a report from S&P Capital IQ in March found that, on average, yields from European high yield debt have fallen by 5% over the past year, while the risks of default have doubled - but this has failed to deter investors.
Last month private bank Coutts released a statement on its position on high yield bonds following reports that it was warning clients against exposure to the sector. ‘We are cautious on certain high yield sectors, including Asian high yield,” the bank says.
Risk/reward pay-off continues
However, Coutts adds that high yield bonds are sufficiently compensating investors for the risk they take. And despite historically low yields and signs the eurozone isn’t out of the woods yet, investors are expected to continue to flood the high yield bond market.
‘Global investors have found themselves in a situation where first cash rates were unattractive, then government bonds, then investment grade bonds and now high yield bonds,’ says Becket.
‘People talk about opportunities in high yield because on a relative basis it looks good. At the moment the world is enjoying low inflation and we have very low interest rates, but at some point those things will change and that poses a risk.’
So far, the outlook for the high yield market continues to appear solid, says Sparks: ‘The overall market environment in 2013 will be one that should remain hospitable for high yield bonds; there may be the occasional short-term correction but a protracted bear market is unlikely.
‘The credit cycle is now approaching its fifth year since recovering from the 2008-09 default wave; high yield credit fundamentals remain solid, and lingering macro risks have kept management teams cautious with respect to balance sheet and liquidity management. This year may be another year that global high yield, like corporate bonds in general, remain in the sweet spot.’
Others agree that it may be some time before the sector begins to suffer and investors shun it in favour of other income-producing investments. Milburn says: ‘With such strong demand for yield, any setback will be greeted by investors looking to “buy the dip” unless there is a significant shock, such as a re-emergence of the euro existential crisis.
‘The fundamentals are fine, and if you can avoid the idiosyncratic downside risks then you can still capture mid single-digit yield opportunities. Valuations are a little stretched, but they are in many asset classes partly due to monetary policy. While the high yield asset class might not win any beauty contests, it is far from looking ugly.’
For some, the risks of the high yield sector will outweigh the potential rewards, but yield-starved investors are still being tempted by its offerings, given the poor returns elsewhere. Unless there is a sudden economic shock, this year is expected to see many investors continue to participate in the high yield ‘risk on’ market in pursuit of income.