Tighter spreads force serious selections

High yield bond funds prospered last year as investors’ risk appetite increased. This not only drove the recovery in equities, but also the riskier corporate bonds, known as high yield. The Lehman Global High Yield index, for example, increased in value by 32.42 per cent in 2003.

But following last year’s impressive returns, some intermediaries have expressed concerns over the sector’s future outlook. The spreads of high yield bonds with investment grade and treasury bonds have narrowed significantly. And with performance beginning to suffer, US high yield funds were hit with a net outflow of $392.2m (€315.75m) in the week to 25 February.

This negative view is disputed by Roberta Goss, high yield product manager at Goldman Sachs Asset Management. She argues spreads between treasuries and single B bonds are still attractive at an average of about 400 basis points, down 20 per cent since last summer. Ms Goss says these spreads are in line with the average between 1993 and 1998. However, her fund has underperformed the Lehman index over one, three and five years.

Declining defaults

According to Ms Goss, the spreads reflect expectations of low and falling default rates. While in 2003 the default rate was 5.4 per cent, they are currently at 5 per cent and rating agencies Moodys and Altman believe they could reach as low as 3 to 3.5 per cent this year.

Ms Goss adds that default rates were only 0.35 per cent in the fourth quarter of 2003, which was the lowest level since 1997.

Linked to the default rate, the other reason why Ms Goss is comfortable with the relatively tight spreads of 400 basis points are the prospects for a global economic recovery. This is reflected in the declining default rates. An improved economic environment makes it less likely companies will go into default or be downgraded and therefore the premium of high yield over investment grade bonds will tend to be less risky than over the past few years, she argues.

Margie Patel, manager of the Pioneer US High Yield Corporate Bond fund, says the performance of high yield bonds is more closely linked to the fortunes of equities than government debt. This is reflected in the fact that default rates have fallen from more than 10 per cent in January 2002 to 5 per cent currently.

‘There is a limit to the capital appreciation that can be enjoyed ’

Margie Patel, Pioneer

Ms Patel, who returned 4.26 per cent in the three years to 9 February 2004, compared to 3.96 per cent by the Lehman index, believes spreads will remain narrow (they are at their narrowest since spring 1998) until the US Federal Reserve tightens short-term rates. However, she has doubts about the Fed’s intentions.

“There is no sign of inflation rising and the Federal Reserve does not want to be where it was in the spring of 2003 when there were fears about deflation,” says Ms Patel.

“It is unlikely that interest rates in the US will be moved before the presidential election in the autumn.”

Appetite for risk

Given the fall in default rates and interest rates to 1 per cent in the US and 2 per cent in Europe, Ms Patel argues that the extra income from high yield bonds is attractive.

“Investors have already had the capital appreciation last year from high yield bonds,” says Ms Patel. “The income is more attractive than base rates and the 3 to 4 per cent from investment grade debt.” One year ago, she points out, the average price of a high yield bond was 90 cents (€0.72) where a single B is now $105.5 (€84.93) and BB is $108 (€86.95).

“The risk of corporate bankruptcies is low at the moment and by investing in high yield you are receiving a better income than from risk-free investments,” adds Ms Patel. “Money market rates are low and the economy is looking strong so the premium of high yield is worth the risk.”

Going forward, Ms Patel sees better opportunities in “good quality” BB bonds than other areas of high yield. “This is because the chances of default are low. We like companies with better liquidity and information flow.”

As an example, Ms Patel’s fund has a 20 per cent exposure to technology whereas the index weighting is only 4 per cent. Technology is under-represented in the high yield market, she argues. Around 45 per cent of the fund is invested in convertible bonds to gain greater market exposure, although it reached 75 per cent in 2002. She says convertible bonds enable the fund to access sectors not well represented by high yield bonds. Furthermore, convertible bonds can gain an equity uplift that is closed to high yield bondholders.

“There is a limit to the capital appreciation that can be enjoyed by high yield bonds,” explains Ms Patel. “The problem with high yield bonds is that they run into call prices.”

Most of the convertible bonds held within the Pioneer fund are small cap companies, says Ms Patel. She adds that investors should expect a return of 5 per cent this year from high yield.

Keith Swabey, client portfolio manager at JP Morgan Fleming, says the narrowing in spreads reflects the greater appetite for risk among investors over the past year as they turned to high yield bonds rather than treasuries or investment grade debt.

He argues this was driven by the end of the conflict in Iraq, the improvement in the global economic environment, greater cashflow and increased profitability of companies. But he admits that high yield bonds have gone from cheap a year ago to fair value now. The JPMF Global High Yield Bond fund returned 23.2 and 22.6 per cent over one and three years respectively to 9 February 2004, well ahead of the Lehman benchmark.

Best returns

Mr Swabey argues high yield will offer the best returns in the fixed interest asset class this year. He expects 6 to 8 per cent total return from high yield compared to 3 to 5 per cent from investment grade. He believes gilts will be harder hit by the expected rise in interest rates than high yield debt. The degree to which returns from fixed interest will be affected will naturally be determined, says Mr Swabey, by how far rates increase and the speed at which they rise. A sudden increase will have a greater impact as markets do not like unexpected movements.

Despite this relatively optimistic outlook, Mr Swabey stresses investors need to be selective about which high yield bonds they buy. “There are still risks in high yield, as we saw with Parmalat and Ahold last year.”

Ian Spreadbury, manager of the Fidelity Funds European High Yield fund, which has trashed the Lehman index over one and three years, agrees investors have to be more selective in 2004 than last year, when low investment grade yields boosted demand for for sub-investment grade debt.

“Since October 2002, the high yield market has witnessed a gradual improvement in credit quality, with many issuers taking advantage of the favourable interest rate environment to refinance or reduce the level of debt in their balance sheets,” says Mr Spreadbury.

“Needless to say, the high number of defaults in 2002 contributed to this but we believe company specific events such as these can be avoided by fundamental company analysis.”