Rising interest rates and inflation have prompted investors to look for new sources of income and diversification, and one area attracting considerable attention has been the high-yield bond sector.
These bonds are essentially corporate credit with a junk rating which pays an attractive coupon to compensate the elevated risk. For example, they may be issued by a company that already has a lot of debt, and the bonds could be situated well down the capital structure, which could mean they do not get paid out if the company goes bust.
Unlike other bonds, high-yield bonds tend to be more correlated with equity markets. This is because high-yield bonds are linked to the business results and fundamentals of the company that issue the bond, as well as the general health of the economy.
Despite higher risks, investors are rewarded handsomely – many yield over 8% compared with 5%-6% for investment grade, which are the safest class of corporate credit. Moreover, high-yield bonds are much less volatile than equities. Over the past five years, the US high-yield market has produced an annualised return of 3.2% compared to 4.2% for the Russell 2000 Index, but with only 40% of the volatility.
The attraction of high yield has grown largely because the quality of the sector has been rising. “High yield has evolved into an asset class that warrants a core position for investors,” says Jack Stephenson, US fixed income investment specialist at AXA Investment Management.
Credit ratings – Moody’s, Standard & Poor’s and Fitch – assign ratings to bonds. A bit like grading homework, AAA is given for the ‘highest quality’ bonds, while ‘BB’ to ‘D’ are assigned to riskier high-yield bonds.
Stephenson points out that the high-yield bond market has the best rating – ‘BB’ – in a decade.
“A lot of this is due to the market’s move up in quality, with approximately 50% rated BB today – its highest level in 10 years, while CCC-rated bonds account for just 11% of the overall market – the lowest level in 10 years,” he said.
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This implies that default levels will be relatively low, and the consensus is indeed that they will rise to manageable levels of perhaps 2%-4% for 2023, in line with long-term averages.
However, rising rates and a slowing economy are causing difficulties for heavily indebted companies, points out David Forgash, managing director and portfolio manager at PIMCO, a bond investment specialist.
He adds that sectors such as media, telecom and healthcare are facing the most challenges, while consumer service sectors such as leisure, gaming and airline, and non-cyclical sectors like food and beverages, utilities and pharma, are performing better.
But despite these challenges, he thinks “most of the high-yield market is in a strong position to handle higher interest costs and a slowing economy”.
He adds: “Many issuers secured low funding costs during the low rate environment in 2021. Companies are also taking steps to improve their situation, such as buying back their own bonds at discounted prices and using excess cash flow to pay down expensive debt.”
High-yield bonds and interest rates
Another attraction is that high-yield bonds are less exposed to interest rate risk because they typically have maturities of less than 10 years, which is much shorter than investment grade bonds.
Different bonds react differently to rising interest rates, which investors have been starkly reminded of over the past 18 months during the tightening of monetary policy.
As Dzmitry Lipski, head of funds research at interactive investor, points out: “A 1% rise in yields will have a much larger impact on the price of longer-maturity government bonds compared to shorter-maturity bonds. This means short duration exposure to bonds could help investors reduce the impact of rising interest rates and market volatility.
“Furthermore, investment grade, high-yield and emerging market bonds are considered to be less sensitive to interest rates than government bonds, so their price return is better in a rising rate environment. They usually have higher yields, and their total return is also better.
“Given the bond market’s volatility last year, both global investment grade and high yield are still attractively valued looking at spreads and compensation for potential default risk, while their level of income generation is also appealing versus other asset classes.”
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In fact, high-yield bonds outperformed both investment grade and government bonds over the year, which seems counterintuitive in a difficult macro environment as higher beta investments do not usually do well when sentiment is poor.
Although the high-yield sector has traditionally been seen as vulnerable to an economic downturn, it currently stands to benefit whichever way the economy moves.
Even in the two negative scenarios – a recession, and an environment of higher interest rates for longer – some bond fund managers, including says Al Cattermole, portfolio manager at Mirabaud, are confident on the prospects for high-yield bonds.
“He says: High-yield bonds currently offer genuinely high yields with the fairly unusual situation of a similar contribution from both government rates and credit spreads.
“This creates a buffer for total returns, no matter what the economic climate. A weaker economy would see wider spreads but lower government rates as we move to the easing part of the cycle, whereas stronger for longer would put pressure on rates but spreads can return to pre-crisis levels, supported by increasingly higher coupons from the new issue market. This offers a very positive range of outcomes across multiple scenarios, with attractive downside protection.”
What happens if there is a recession?
Moreover, if the downturn becomes a recession, inflation and rate hikes will be the main causes, rather than the asset bubbles that caused many previous recessions and inflicted greater damage on corporate earnings, says Michael Della Vedova, portfolio manager of the T. Rowe Price Global High Yield Opportunities Bond fund.
“An economic downturn will weigh on profit margins and cash generation, but while this may lead to a deterioration in balance sheets, most companies are entering this from a position of strength,” says Della.
He adds: “Interest coverage ratios, which determine how able a company is to pay interest on its debt, are high, while leverage ratios, which show how much of a company’s capital comes from debt, are relatively low.”
Where it could go wrong
There are three reasons investors might hold high-yield bonds – capital returns, income and diversification.
But not all experts are enthusiastic. Becky Qin, a fund manager at Fidelity International, is concerned about the outlook for default rates for the high-yield bond market.
Qin notes that while defaults are relatively low, she expects them to rise, especially if interest rates stay high into 2024.
She says: “Higher for longer rates means that companies issuing bonds will have to do so at much higher rates than a few years ago, putting weaker companies under pressure.”
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Default rates depend, of course, on the issuer’s individual business and financial profile, and rising interest rates have an impact on consumer behaviour. “The big drivers are employment and disposable income,” says David Newman, chief investment officer for global high yield at Allianz Global Investors.
He adds: “Similarly for corporates the driver will be profitability post interest costs and this will differ across businesses. Most high-yield issuers have fixed-rate debt and will only see the impact of rising rates when they need to refinance. The best measure of this is the refinancing wall. This is small in 2024 but steps up in 2025 and from that point on the refinancing wall is higher than it has been in the last eight years due to closures of capital markets in the Covid and rapid rate-rise periods.”
As for diversification, the sector exposure of high-yield issuers is different to, say, companies found in the S&P 500. High yield is less tech heavy and has little exposure to large companies. Higher rates are likely to hit the smaller, lower-quality companies that are geared to the real economy first. This type of issuer is more often found in direct lending and leveraged loans - universes that sometimes have overlapping issuers, leading to high correlation, argues Qin.
Lipski likes Royal London Global Bond Opportunities fund, which currently yields 5.75% and has a flexible approach across global fixed income, with a focus on short duration.
“The fund benefits from a stable team and a differentiated approach, which includes Royal London’s capabilities in under-researched parts of the market, including unrated bonds,” Lipski says.
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Last year was the fund’s first negative calendar year (it launched in December 2015), but managed to outperform both the Bloomberg Global High Yield GBP Hedged index and the high-yield bond fund sector average.
Rachid Semaoune, senior fund manager at Royal London Asset Management, said: “While high-yield defaults are expected to modestly increase in the medium term, our Global Bond Opportunities and Sterling Extra Yield funds seek to invest in asset-heavy sectors such as industrials and in bonds offering downside protection through security or covenants, where recovery prospects are higher. The funds have little exposure to highly leveraged, economically sensitive companies.”
How bond funds work
Bond funds are constantly buying and selling new bonds, or holding them to maturity and reinvesting the capital that’s returned. This means changes in the price of bonds will impact the value of a bond fund.
As interest rates have been rising in the UK over the past 18 months or so, bond funds that pay investors in pounds are falling in value. This means that even though yields are higher, the total return of many bond funds (which includes income and capital gains/losses) has been negative given this rising interest rate backdrop.
Open-ended bond funds, like open-ended equity funds, grow and shrink as money flows in and out. This means that new money gives fund managers capital to invest, but outflows mean that the fund manager has to sell bonds (or use its cash position) to return money to investors.
This makes them suitable for investing in highly liquid parts of the bond market, but less suitable for investing in illiquid bonds. The most liquid bonds are developed market government and investment grade corporate bonds, but global high-yield bonds is also a large and commonly traded market.
On the other hand, investment trusts are arguably better suited to hard-to-sell parts of the bond market, such as specialist bonds that are not frequently traded.
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