High yield bond returns cater to risk-on investors

US high yield corporate bonds including CCC-rated bonds made total returns of about 12 per cent in the first three quarters of the year, while European high yield made even more with the broad market, including CCCs, returning 20 per cent and BBs and Bs returning 19 per cent.

While this severely curtails scope for further strong outperformance, rising risk appetite continues to drive unprecedented demand for corporate bonds, particularly high yield, as investors turn away from government bonds that are paying less than 1 per cent for investments of five years.

High yield also compares well with equity in the current climate. “Euro high yield is a risk asset that in the long run offers an average return of close to 8 per cent per annum, with a significant volatility (7-9 per cent) for a fixed income security, but approximately half the volatility of equity (15 per cent plus),” says Olivier Monnoyeur, portfolio manager at BNP Paribas. His own conservative BNPP Bond Euro High Yield C fund excludes both CCCs and subordinated debt and is measured against a benchmark yielding 6 per cent compared with 2.3 per cent for investment grade and government bonds in safe countries paying 1.5-2 per cent on a 10 year basis.

“If you bear in mind the time horizon for most high yield bonds is five years, they compare well with the payout on five year Germany bonds at 52 cents,” says Mr Monnoyeur.

Corporates have been taking advantage of the increase in risk appetite to refinance their debt, with new dollar-denominated high yield issuance of $261bn (€200bn) for the first three quarters of the year surpassing last year’s full-year total of $246bn and September’s $45bn issuance is one of the highest on record.

LOOKING FORWARD

“The first nine months of the year have produced a period of steady positive returns even though there have been moments of potential world events that could rile the market,” says David Bowen, investment fund manager at corporate credit specialists Muzinich.

“The market is up partly because central bankers are flooding the market with liquidity to encourage people to continue buying risk assets, but there will be headwinds. As we move through the year the focus will shift to the US election and the aftermath – post election, a lame duck Congress may not take action on a number of fiscal issues,” he says.

“Then there is always ongoing risk around Greece and Spain, and it’s fair to say we live in a truly unpredictable world – China, Iran and Israel could all kick off. You could say we are due for something to give the market a pause. But then, you could have said that in any of the last three months, so we are a bit cautious, but that does not mean that the market can’t continue respectably for the rest of the year.”

A finely balanced economy will be a prerequisite for that to happen. If the economy becomes overheated then government bonds could squeeze yields, particularly at the lower risk end of the market where there is more interest rate risk, and the technicals would worsen as investors switched to equities. At the other end of the spectrum, if the economy slows then default rates could pick up, which would particularly impact the end that carries most credit risk.

There is also speculation that a big upturn in equity markets could reverse the huge inflows into high yield exchange traded funds (ETFs) and de-stabilise the market. This may be overhyped however as these ETFs did not suffer outflows during the volatility in April and May, and ETFs comprise only $30bn of the $1.1tn US high yield market.

Within Europe, peripheral corporate bonds continued to outperform their peers in core markets, with non-financials outperforming by almost 4 percentage points since the ECB implemented its monetary policy at the end of 2011. However credit ratings are under pressure, causing spread compression to stall in the autumn.

Opinion on whether further compression in peripheral Europe is possible in the coming months divides the market, and a marked shift in the landscape has driven managers to examine a wider range of indicators such as country, sector, rating, cashflow and sensitivity, whereas rating used to be the predominant factor.

“Peripheral credits are the most interesting part of the market and where we still see room for upside,” says Raffaella Tommaselli, co-fund manager of Eurizon Capital’s high yield funds. “Clearly we could still experience volatility but the ‘ECB PUT’ has given a floor to the market. Besides that, the inflows in the European high yield market have been very strong for most of the year and many investors missed the rally and have a lot of cash to put to work. This liquidity buffer of investors will probably continue to support the market and prevent any technical meltdown.”

Challenges to this view focus either on political risks such as delays in the ECB’s outright monetary transactions (OMT) programme, or from the macro picture in terms of further weakening of southern European economies. “Portugal and Greece are in a fragile position and it is too early to get back into them,” says Thierry Lebaupain, high yield portfolio manager at Amundi.

“We are also underweight on high yield financials – particularly Spain and Portugal. Generally, we are underweight broad cyclical names exposed to global GDP evolution as the recovery is fragile and visibility lacking. The tail risk has been pushed away by the actions of the ECB but growth prospects remain very challenging.”

CASH AND CARRY

In a market that will not tighten much more, the opportunities are in cash flow-generating companies with steady business models that could absorb a slump, and carry is all important. “The classic bull case for high yields would suggest an overweight in high leverage, low rated, highly cyclical names as it relies on growth in the economy,” says Elena Musumeci, Ms Tommaselli’s co-fund manager at Italian group Eurizon Capital.

“But as a result of the constructive stance coming from a reduction in the tail risks in the eurozone and uncertainties on the macro picture, it is appropriate to focus on the strongest credits, avoiding negative free cash flow companies in very cyclical sectors, typically B3/CCC bonds.”

Generally, balance sheets in high yield markets have strengthened however and although the rate of rebuilding them may have slowed, leverage is ticking down, with no resurgence in highly leveraged buyouts, and the cost of capital remains cheap.

The market is now discounting 35 per cent cumulative five-year default rates, which is still pessimistically high by realised historic standards.

“Corporates remain cautious, as they have been for four years, and are not spending much on capital expenditure or expanding rapidly, which is not so good for equities but is excellent for debt holders,” says Muzinich’s Mr Bowen.

“For time horizons of six months to a year, this could continue to be a good period because the technicals and fundamentals are strong and the asset class compares well with other choices. While high yield is not as attractive as nine months ago, relative to equities, which are up 15 per cent this year in the US, it is attractive. In some sense we are not expecting great earnings growth so equities are actually more exposed.”

The traditional rulebook on sectors has been jettisoned against this unusual economic backdrop.

“It’s an idiosyncratic market,” says Ben Pakenham, portfolio manager at Aberdeen Asset Management. “It is not as simple as certain companies being cyclical and others being defensive. For example autos are cyclical but have done well, helped by government stimuli, while petrochemicals are also cyclical but are often dependent on Asian growth and are susceptible to inventory write downs and broadly struggled in the second quarter. We think autos such as Peugeot are expensive, however, as the upside is priced in and there is a lot of downside. European car sales volumes have turned south fairly dramatically recently.”

Retail is a bifurcated market, explains Mr Packenham. “The good companies tend to be luxury companies with access to China, but we are more cautious about budget and value retailers as these are more buffeted by the struggling consumer, particularly in the lower demographic groupings, the area most under pressure on the job front, and bearing a disproportionate amount of the tax burden. Budget goods are more influenced by any rise in the cost of the commodities that go into them. For example, the cost of cotton in a £5 (€6) T-shirt will be a bigger proportion of the cost than in an expensive item,” he explains.

“Housing construction is at the opposite end of the spectrum from autos – it is a market that is cheap. Big German construction companies have not rebounded since 2009 and the downside risk is more limited therefore.” Mr Packenham likes Polypipe, a lowly leveraged piping company that sells to construction markets in the UK and France.

High yield funds have also gained traction as money market funds. For example, the Petercam L Bonds EUR Short Term High Yield fund focuses on less volatile European high yield with maximum term of four years.

“For as long time this part of the market was overlooked but capturing the value of short term bonds pays a 4.2 per cent yield,” says Thierry Larose, fund manager at Petercam. “This fund is particularly popular at the moment as investors are still really defensive.”

Invest but stay close to the benchmark

“We think that high yield can play an important role in bond portfolios given the current market environment of low yields,” says Jeff Mortimer, director of investment strategy at BNY Mellon Wealth Management.

“We see some relative risk in Treasuries relative to high yield on a risk adjusted total return basis. In a muddle-through economy high yield should do well, and investors will know that even if spreads widen the coupon collected in the interim will have been a buffer.”

The wealth manager is currently suggesting clients go underweight Treasuries and switch some of that to high yield and emerging market debt within a diversified fixed interest holding. Active managers are recommended, as downside protection can be improved by defensive positioning and holding cash, rather than a preoccupation with the benchmark.

However, Mr Mortimer does not like active managers to stray too far from the benchmark as this makes it harder to predict how they will perform. As an asset class, high yield sits in the middle of the market efficiency spectrum and is therefore somewhere in the centre in respect of how active he prefers its managers to be.

Fees should be scrutinised when selecting high yield bond funds as this is not an asset class such as small cap equities where an astronomical return could make the fees disappear.

Recent research from Morningstar has found further evidence of the link between high fund fees and low performance. It reviewed all 442 bond funds and found that the best-performing quintile displayed the lowest average TER of 0.67 per cent while the worst-performing quintile displayed the highest average TER of 1.05 per cent.

“Even in the best of times, the impact of fees on fixed income funds is especially high, given the relative difficulty in beating fixed-interest benchmarks and the relatively compact spread of returns in fixed-interest sectors,” says Christopher Traulsen, director of fund research at Morningstar.

“In today’s low-yield environment, these factors loom all the larger. The unavoidable implication from our research is that investors would be extremely remiss not to focus on costs as a key criterion when selecting a fixed interest fund.”

VIEW FROM MORNINGSTAR

Spectacular rebound

While European high yield funds suffered more than other fixed-income categories during the market downturn of 2011, the sector made a spectacular comeback over the first nine months of 2012. From 16 September 2011 to 18 September 2012, funds in this category delivered on average 17.7 per cent . While healthier fundamentals have certainly played in favour of these issuers, the category’s resilience can also be explained by technical factors. With high-quality corporate bonds becoming increasingly expensive, and yields on short-term instruments converging to zero, many investors on the hunt for yield have turned to speculative-grade bonds.

Funds which had the highest exposure to financials and cyclical issuers captured most of the market rally. One of the top performers (22.4 per cent ) was HSBC GIF Euro High Yield Bond. The fund manager, Philippe Igigabel, has long been convinced that banks have done a tremendous job cleaning up their balance sheets after the credit crisis, and continues to believe in the sector’s potential in spite of the current recessionary environment.

Fidelity European High Yield, lagged the category average over the past 12 months, returning only 15.8 per cent. Manager Ian Spreadbury builds a portfolio of diversified and uncorrelated positions, using best ideas from Fidelity’s large analyst team. He avoids concentrated bets on a single sector, and the fund has historically been less exposed to financials than some of its competitors. As of August 2012, the fund also held a significant cash stake (including a 6 per cent holding in short-term German government debt), in order to be able to take advantage of new issues and ensure adequate liquidity for the portfolio.

Mara Dobrescu, fund analyst at Morningstar’s Paris office