Should clients plunge into high yield?

YES

Willem Sels, UK Head of Investment Strategy, HSBC Private Bank

We continue to overweight high yield (HY) in our portfolios and expect returns in the high singledigits in 2013. That is less than last year’s stellar 15.8 per cent performance, and probably less than what we can expect for equities, but considerably more than what investors are likely to get in cash, government bonds or investment grade credit.

Investment decisions should map investors’ risk appetite and constraints against assets’ expected returns. Most investors still consider fixed income as a core part of their portfolios because of its diversification benefits and predictable income, and as long as this is the case, they will look for the best risk-adjusted value within the bond market. Within that area, we think only emerging market local currency debt may outperform HY, but this may come with somewhat higher volatility.

In particular, HY should continue to benefit from the search for yield. Central bank action has clearly made sovereign bonds unattractive, and this initially led investors to move into investment grade bonds. But as investment grade spreads have moved close to 2006 lows, investors are likely to move further down the credit spectrum from investment grade to high yield, helping performance.

Some commentators fear the impact of rising government bond yields, but we do not think this will kill off the search for yield. We strongly doubt central banks will allow yields to spike until the economy has improved much further. Even if yields were to rise though, this would mainly hurt better rated credit, while impacting high yield bonds much less: if improving risk appetite were to be the trigger for a bond market sell-off, this should help spreadcompression, limiting the damage to high yield.

Still, because of the risk of somewhat higher bond yields in the course of 2013, we limit the duration of our bond portfolios. Short-dated HY can be a good addition to portfolios, because it offers a very similar spread as long-dated HY, while at the same time helping to limit overall portfolio duration.

Default rates are another important driver of HY performance. Defaults spiked in 2009, but then came down sharply, falling back to multi-year lows. Although the default rate has started to rise slightly again, rating agencies expect it to stay well below the historical average. This could surprise as the global economic recovery may remain shallow, but it is in line with banks’ falling provisioning for bad commercial loans. It also illustrates that what drives defaults is more complex than just economic growth. For example, the probability of default for HY bonds rises three to four years after issuance, and low issuance in 2008-2010 should thus help keep defaults low for a year or so.

Another misconception is that the rating composition of the market has deteriorated, while in fact the weight of CCCs (18.7 per cent currently) is in line with the historical average.

Looking at the historical relationship between spreads and the default rate, we think HY fairly compensates for a 4 per cent default rate, somewhat higher than what rating agencies expect. ‘Fair’ may not sound very exciting, but in our view it is much better than the overvalued territory that characterises so much of the rest of the bond market.

Of course, high yield remains a riskier asset. Our overweight position is in line with our positive view on equity markets, which is based on a gradual recovery of the global economy, reduced recession risks, ongoing policy support and generally declining risk premia.

High yield can thus fulfil two roles in fixed income portfolios. First, it can add a somewhat more positive view on the economic cycle, where investors are unwilling to shift too much money into equities. Secondly, it can help achieve the income requirement for many investors, within a bond market where income is increasingly rare. As a result, we think HY will continue to see good investor flows in 2013, which should help support performance.

Peter Branner, SEB Asset Management

NO

Peter Branner, Global CIO, SEB Asset Management

Fixed income investors enjoyed a very stable year in 2012, and things were especially good for the corporate and high yield segment in particular. The expansive policies from central banks has been very supportive and proved the driving force throughout the year. After a temporary solution for the fiscal cliff was reached, it is time to consider what comes next. How should smart investors look at fixed income now?

For a long time, market players have had a sceptical attitude towards risky assets, based on the problems that have existed, and still exist, around the world. Capital has consequently moved from stockmarkets into bond markets and in particular corporate credit. But these conditions could well change.

To some extent, we can view capital markets as communicating vessels. Capital flows into one asset until it is full (expensive), then gradually into another that is available (cheap). Fundamental events serve as the mechanism that moves capital.

Perhaps debt deleveraging has come such a long way in parts of the world that the risks which drove investors into defensive behaviour are no longer so relevant, but instead have become manageable. The eurozone crisis, US household debt and the Chinese economic situation are examples of such risks. If these risks “normalise” and if the relatively good underlying trend in the US and China instead becomes the main theme, then capital will gradually seek risk in order to boost potential returns.

Putting money into stockmarkets will make more and more sense if there is a greater focus on the recovery. The road to recovery will still be lined by financial risks. Yet opportunities exist, and returns will be generated in places other than traditional industrialised countries.

We have a positive outlook on the continuation of the extremely expansive policy from central banks. “Low for long” will be “low for longer” and this should keep interest rates low for the year to come. That is good news for corporate bonds and high yield, but the next big movement is upwards. After 30 years of falling rates, we can be sure about one thing: the next 30 years will not see a repeat of that.

As professional investors we know that some specific asset classes will be better than others within a specific time frame. And that it is very hard to time this perfectly. Therefore, we strive to count on possibilities and weigh different assets versus others, and in our allocation put higher weights on assets we like more.

Right now we are lowering our expectations for high yield, not because high yield is “bad because it’s bad”, but in the relative game of investing, other asset classes look more and more attractive. You could say that corporate bonds are going to good from fantastic. And that riskier assets might go from bad to good, but with a positive outlook.

In conclusion, there are signals indicating positive as well as negative outlooks for yields and credits. From an asset allocation point of view the latest rally in equity has taken us closer to equilibrium between equities and bonds, and we think 2013 is yet another year that is better for equity than for credits and high yield.