Risks vs rewards of bond funds yielding over 6%

In a world which seems to get riskier by the month, it might seem odd to be looking at high-yield bonds.   

The sector has traditionally not been for the faint-hearted. High-yield bonds are loans to companies with weaker credit ratings, where investors are compensated for taking on more risk by being paid a higher interest rate.

• Invest with ii: High Yield Bonds| Fixed Income Investing| Investing in Bonds

Unlike lending to a blue-chip company such as Microsoft or a government, where yields are lower due to the perceived strength of the borrower, investors receive a meaningful yield premium to reflect the higher chance of default.

“The key risk is that defaults tend to rise when economic conditions deteriorate and refinancing becomes more difficult,” said Darius McDermott, managing director of FundCalibre.

Improving levels of credit quality

James Ringer, a bond fund manager at Schroders, makes the case that the risk of this area of the fixed-income market is now more manageable for investors.

“There has been a structural improvement in the credit quality,” he says. Ringer points out that bonds with a credit rating of BB, which is just one notch lower than the lowest investment-grade rating, make up 60% of the asset class now, up from 30% in the late 1990s.

Investment-grade bonds are deemed the safest types of bond and have ratings from Baa or BBB and upwards. Whereas high-yield bonds have credit ratings of Ba or BB and below. 

He adds that unlike other bond types, high-yield bonds are less sensitive to interest rate changes. Therefore, in the event of the next interest rate move being an increase in response to the expectations of rising levels of inflation following the US-Israel war with Iran, this bond area could prove to be less volatile.

“Given relatively higher yields and lower interest-rate sensitivity compared to their investment-grade credit and government bond peers, high-yield bonds can provide more cushion against any potential rise in interest rates,” says Ringer.

• Bond Boss: an income play less dependent on rate changes
• Fund Focus: where to hide in the market sell-off?
• Bond Boss: myth vs market reality for this high-yielding area

Sander Bus, chief investment officer for high yield at Robeco, agrees: “The quality of high-yield bonds is much better now. They are typically large companies, and the expected default rate has come down.

“We invest in companies we think will still be around in the next decade. That means old economy like chemicals and minerals rather than technology.”

Nick Gait, investment director at Tideway Investment, believes high yield offers attractive long-term returns, which have historically been competitive with equities on a risk-adjusted basis and have typically shorter duration than many fixed-income assets, meaning lower sensitivity to moves in interest rates.

“Companies are strongly incentivised to meet their debt obligations, as defaulting makes it difficult to access capital markets again,” he said. “As a result, high yield sits in a useful middle ground – offering equity-like returns but with the contractual protections of fixed income.”

Royal London Sterling Extra Yield Bond, with a dividend yield of 6.6%, is among the funds it currently uses in its portfolio.

Ken Orchard, head of international fixed income at T. Rowe Price, notes that another reason to be positive is that high-yield issuance has picked up as companies refinance and fund capital spending in areas such as artificial intelligence (AI) and digital infrastructure.

“New deals have generally been well subscribed, showing strong demand for yield even with higher base rates.

“Despite recent volatility, the growth backdrop looks reasonably resilient and most high-yield issuers, particularly in developed markets, remain fundamentally supported,” he said.

Broader options

Perhaps on the more cautious side sits Philip Matthews, fund manager at Wise Funds. It invests in the Premier Miton Strategic Monthly Income Bond C acc and Vontobel TwentyFour Strategic Income I GBP, which have respective yields of 5.6% and 6%.

“They are both relatively cautiously positioned at the moment, favouring investment grade over high-yield exposure, given the historically tight spreads corporate bond yields trade at relative to government bonds,” he said.

“Corporate bonds offer higher yields but are more exposed to economic growth expectations and as investors move out of investment-grade bonds into higher-yield bonds, the key is to determine where you believe we are in the economic cycle and whether the incremental yield is rewarding you for the higher level of credit risk you are taking on.”

• How to build a cautious ISA portfolio
• How to build a medium-risk ISA portfolio
• How to build a higher-risk ISA portfolio

The current conflict in Iran further complicates the picture.

“The market reaction so far has been relatively calm with expectations for further interest rate cuts later this year moderating, longer-dated bond yields rising and credit spreads for both investment-grade and high-yield bonds starting to widen,” Matthews said.

Credit spreads are the difference in yield between safe and riskier bonds of a similar lifespan.

Matthews notes as the “yields available from investment-grade corporate bonds look sufficiently attractive” (with such bonds typically yielding around 5%), he does not feel compelled to look for an extra chunk of income in the high-yield bond space.

Asset-backed securities

Wise Funds also holds TwentyFour Income Ord (LSE:TFIF), which is an investment trust investing into less liquid, higher-yielding UK and European asset-backed securities. Its dividend yield is 6.6%.

These are assets such as home equity or bank loans pooled together. The main challenges are again credit risk, defaults and market risks from economic downturns.

The TwentyFour Income Fund has a target annual net total return of between 6% and 9% per year. Its biggest exposure is to Collateralized Loan Obligations (CLOs) and Residential Mortgage-Backed Securities.

“The yield on the portfolio remains very healthy and, so far, the fundamentals for the consumer, unemployment, real wage growth and savings levels, are holding up well. This should be supportive for mortgage-backed securities,” says Matthews said.

A key attraction of ABS and CLOs is that coupons are floating rate. As Matthews notes, investors are protected against shifting expectations for interest rates

McDermott said that he is currently broadly neutral to slightly cautious on high yield. “Yields are reasonably attractive in absolute terms, but spreads are not especially wide given the level of geopolitical uncertainty. Historically, periods of rising conflict or economic stress tend to see spreads widen further, which suggests patience may be warranted,” he said.

• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis
• Unloved adventurous areas that warrant a closer look

In terms of picks, he favours the Artemis Funds (Lux) Global High Yield Bond I GBP HAcc, which he said, “focuses on under-researched and inefficiently priced opportunities further down the credit spectrum, with a global remit that allows the fund to uncover value that more regionally constrained peers may miss”. Its yield is 6.6%.

For asset-backed exposure, he said that the MI TwentyFour AM Dynamic Bond I Acc “has tended to deliver one of the more attractive income profiles within the sector.” Its yield is 6%.

Another area of high yield is emerging market debt, which includes government to corporate bonds and can be issued in either local or hard (typically US dollar) currency. That choice has a huge impact on risk drivers.

“While there are signs of improving fundamentals in parts of emerging markets, returns remain highly country-specific. After a strong start to the year, the outlook has become more uncertain as rising oil prices have supported a stronger US dollar, which typically acts as a headwind for emerging markets,” said McDermott.

“However, the longer-term case remains compelling. Emerging markets benefit from stronger demographic trends than developed economies, alongside, in many cases, healthier government balance sheets.”

He likes M&G Emerging Markets Bond GBP I Acc, yielding 7.2%.

“It takes a diversified approach across sovereign and corporate bonds in local and hard currencies,” said McDermott.

What trends are bond managers seeing?

Pieter Staelens, portfolio manager of CVC Income & Growth GBP (LSE:CVCG) buys underperforming loans on the secondaries market and then works with companies to improve their credit ratings. It is yielding 8.5%.

It typically lends to very large companies which are more resilient throughout various macro cycles than smaller companies.

“As inflation could pick up again given potential for renewed supply chain issues and oil price moves, we believe it’s important to be in floating rate credit, said Staelens.