Attractive yields outweigh the risk

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High yield bonds are once again worthy of their name, yielding 10 per cent compared with under 7 per cent earlier in the year.

Many advisers are currently recommending overweight positions in high yield bonds on the basis they are priced for Armageddon default risk. Credit spreads are 900 basis points, which implies a default rate of 8-10 per cent, while the consensus is defaults are likely to remain quite low. The latest three-month default rate was 1.8 per cent on a global basis and 2.1 per cent for the US, according to Moody’s. Its projected default rate for the next 12 months is 1.9 per cent globally and 2.2 per cent in the US, more or less unchanged from recent experience. With gilts and Treasuries yielding under 1 per cent, in theory there is enough extra yield to compensate a cataclysmic default experience.

One indicator is the ratio of ratings downgrades to upgrades, and while this had been steadily improving since 2008, it tipped the other way in August and September, suggesting a worsening scenario.

Most commentators are not perturbed, however. For example, James McDonald, chief investment strategist at Northern Trust, is predicting an average annual default 2.4 per cent for the next five years – half the long-term average of 4.8 per cent – and lower rates in the initial few years owing to low refinancing requirements and healthier balance sheets.

There is particular confidence around the strength of corporate earnings. “From a fixed-income perspective, high yield corporate earnings generally have been reasonable so far this year,” says Russ Covode, portfolio manager at Neuberger Berman.

“Most companies will do well even in a slower-growth environment,” he explains. “That’s because most companies don’t need to grow into their capital structures in order to survive. Leverage levels and balance sheet liquidity right now are reasonable.”

Over the summer, high yield bonds suffered nearly as much as stocks, with which they share many characteristics. Both were hit by the general risk aversion, but European bonds came off much the worst.

“US high yield is currently 865 bspts over Treasuries, having widened from 525 bspts three months ago,” says Colleen Denzler, head of fixed income strategy at Janus Capital. “European high yield is 1049 bspts above European Treasuries as sentiment is more negative and investors are waiting to see how events in Greece and Italy pan out.”

EUROPEAN OPPORTUNITIES

Many fund managers are consequently focusing on Europe, believing investors have been over-cautious and that the region offers better opportunities. Robeco, for example, is overweight Europe because of the huge valuation differences.

“The northern European economic outlook is not much different to the US but the uncertainty around it confers a huge premium,” explains Sander Bus, Robeco’s head of credit investments. “Spreads on US high yield have widened 40 per cent year to date but spreads on European high yield have widened by 80 per cent year to date,” he adds.

“Core Europe is probably stronger than the US so we prefer to invest in companies in the region, although Europe is a much smaller region and weighted at just 15 per cent of the benchmark,” says Roeland Moraal, fund manager of CGF Robeco European High Yield Bonds, who is double the benchmark at 30 per cent.

“European HY as such is largely a North-West (core) European asset class anyway, with much less exposure to peripheral Europe,” adds Mr Moraal. “We like the economic performance of core Europe including the UK, and we like it better than the US. Our overweight is therefore based in core Europe – Germany, Holland, France and also the UK – on firstly the better economic performance of this region, and secondly the much more attractive valuation compared to US high yield.”

CLEARER OUTLOOK

Others prefer the clearer visibility in the US market. “It is possible to get a better handle on where the US is going and the US would be less impacted by another negative event,” says Darren Ruane, senior bond strategist at Investec Wealth & Investments.

“Economic data in the US over the summer got worse, but there is an upside to this, as high yield does better than equities in a low growth environment,” he explains. “In a high growth environment, the temptation is to use spare cash for M&A and share buybacks.”

Mr Ruane also anticipates improved US data in the second half of the year, pointing out that the Japanese tsunami interrupted the supply chain and the oil price rose in the spring because of the Arab uprising, and both factors are unlikely to recur.

Managers are looking for good quality, defensive companies that do not appear to need economic growth to survive, typically food, beverage and packaging companies which are linked to stable non-cyclical markets, with highly visible earnings and the ability to pass on raw materials price increases. Ms Denzler at Janus Capital points out, for example, that while the supermarket sector is up 8.63 per cent year to date, home construction is flat at 0.37 per cent, according to Barclays US bond indices, so there is a wide differential in performance between sectors.

In the same vein, cable companies are popular as internet and TV subscriptions are generally retained even when jobs are lost. Double B-rated bonds are most in demand as they include the rising stars most likely to return to investment grade, such as Ford and medical care company Fresenius.

Ian Spreadbury, manager of Fidelity’s Strategic Bond Fund and MoneyBuilder Income Fund, also favours pharmaceuticals, transport, consumer staples and utilities: “All sectors that contain companies that have a degree of pricing power in a tough operating environment,” he explains. He is avoiding over-concentration in financial bonds as financials are most sensitive to the problems in Europe and weakening economy.

Private equity-sponsored debt is not popular. TXU, the large Texan integrated electric utility company, First Data Corp, Harrah’s Entertainment which runs casinos in Los Vegas, and radio station business Clear Channel Outdoor Holdings fail to impress as they are generally thought to face problems if the economy does not grow.

“There are lots of aggressively financed leveraged buyouts around at the moment,” says Robeco’s Mr Moraal. “Some recent ones have seen 80 per cent of the purchase price constituted by debt.”

Bond issuance is increasingly replacing conventional bank loans in capital structures. Arif Husain, director of European fixed income at Alliance Bernstein, says that some new issues are very attractive, and highlights a recent issue that included a 10 per cent coupon and a yield 1.5-2 per cent wider than existing issuance.

However, the terms of bond issues are increasingly tampered with and the covenant packages are often negotiated in great detail. This weakening in the investor’s protection includes allowing the issuer to incur other debt, changes to the note holders’ put option on change of control, the pari passu sharing of collateral with other creditors including banks and greater use of super-priority debt.

Looking at the complete range of investment alternatives, high yield arguably does not compare well with equities at this juncture, and big defensive blue chips remain a good call for their dividend income.

“Arguably, it has been a golden period for bonds,” says Peter Harrison, CEO of RWC, highlighting some recent data from the London Business School by Dimson, Marsh and Staunton which reveals that although sovereign bonds have returned 6 per cent in the past 30 years, for the previous 80 years they returned only 0.2 per cent.

The asset class could well revert to a more traditional range, Mr Harrison argues, while there are some well established companies such as the pharmaceuticals whose equity yields are higher and offer potential for capital gain.

LIQUIDITY PRESSURE

Andrew Jessop, portfolio manager at Pimco, also believes a reversion has been taking place over the last 15 to 24 months, to a more traditional model where high yield might provide half the return of equity with half the volatility. Nevertheless, he says, high yield will still appeal because investors are looking for a less volatile alternative to equities and are also looking for yield in a low yield environment.

The general sense about the sovereign crises in Europe is that most potential negative outcomes are already accounted for.

“The market view is that some progress will be made by the time the G20 meet in early November, but the problem won’t be solved and it will come and go to the forefront over a number of years,” says David Bowen, portfolio manager at Muzinich.

“Despite the S&P’s downgrade of the US, it is still the closest thing to risk-free that there is, and events such as a possible French rating downgrade are already factored in.”

Short-term volatility a price worth paying

The value of the underlying income stream from high yield bonds could be routinely mispriced, as the sector has displayed favourable risk return dynamics since 1991, according to James McDonald, chief investment strategist at Northern Trust.

He says, for example, that since the end of 2002, high yield has returned an average annual 9.6 per cent, compared with 12.1 per cent for emerging market debt, which falls back to 6.3 per cent after currency fluctuations.

Most advisers believe that high yield is good for a 12-18 month horizon, providing clients are able to ride out short-term volatility.

Alan Higgins, head of investment strategy UK at Coutts, points out that high yield has a negative correlation with government bonds and typically a positive correlation (circa 0.6) with equities, and so should be seen as quasi-equity. He typically suggests an allocation of around 2-3 per cent to high yield, with emerging market debt earmarked a separate 2-5 per cent.

Mr Higgins recommends funds such as those run by Goldman Sachs, Schroders and Pimco, which are fairly defensive within a high yield context.

“The challenge for high yield is the competition from attractive and likely growing yields from high yielding equities,” he says.

“For example, the three biggest holdings in the Coutts UK high income fund are Vodafone, Glaxo and Shell, which all yield over 5 per cent and are growing their dividends.”

Exchange-traded funds (ETFs) also offer another avenue in accessing the sector. The main ones are Barclays Capital High Yield Bond ETF and iShares iBoxx High Yield Corporate Bond ETF, but whether a conventional ETF structure is appropriate for bonds is debatable as each constituent will account for a larger part of the index the greater its level of debt.

View from Morningstar

High risks par for the course

Investors forget from time to time that high returns tend to go hand-in-hand with high risks. So it is not surprising to see funds with good middle and longterm track records producing negative returns over the last year. Nearly all funds in the Morningstar EUR High Yield Bond sector are in the red for that period, except for those that benefited from a positive currency effect.

The last 12 months have been particularly difficult for bonds: a surge of inflation at the start of 2011 put fixed income products under pressure, as operators expected Central Banks to increase rates. However, towards the end of the second quarter it became clear growth was slowing in developed countries, and Greece’s sovereign debt crisis triggered a period of uncertainty for all fixed income products.

While some funds made losses ranging from 10 to almost 20 per cent over the last year, others succeeded in avoiding the same fate. This is the case, for instance, for the Robeco High Yield Bonds and the Fidelity European High Yield funds. The latter, managed by Ian Spreadbury, has consistently delivered above average returns over the years. In 2009, the manager was able to avoid the temptation of financials, and to limit his exposure to that sector to the highest quality issuers.

The Robeco management maintains a portfolio made of three pockets: small-cap issuers, large-cap issuers and opportunistic plays. For this part of the portfolio the managers have the freedom to select all kinds of issues. The ability to allocate up to 35 per cent in investment grade credits might explain why the fund managed to limit losses in difficult times.

Frederic Lorenzini, director of research, Morningstar France