Bonds outperform equities in past decade

High yield is an asset class that generally performs well in the early stages of an economic recovery, and although there is no guarantee it will continue, data on both sides of the Atlantic improved towards the end of 2012.

GDP growth of roughly 0-3 per cent per year is considered to be the sweet spot for high yield issuers and with global growth forecast to be 1.4 per cent in 2013 and 2.2 per cent in 2014, according to the IMF’s GDP growth estimate for advanced economies, conditions should remain favourable.

High yield bonds have delivered equity-like returns but with half the volatility in the past decade. Monthly returns from global high yield have consistently remained in a relatively narrow range, other than during late 2008 and early 2009 when market volatility across all asset classes was at extreme levels. In contrast, returns from global equities are far more volatile.

In the 10 years to the end of 2012 equities delivered a return of 8.7 per cent per year, with annualised volatility of 16.8 per cent. By comparison, global high yield returned 9.2 per cent per year for the same period, but with almost half the volatility.

Expectations are that the low growth environment will continue, while central banks remain committed to accommodative monetary policy for the next 12 to 18 months. Significant increases in government bond yields are therefore unlikely in the near term. Compounding the supportive economic environment, market conditions also remain favourable. With corporate activity rising, so is the opportunity to deliver returns in excess of the market.

The asset class offers excellent stockpicking opportunities. Most companies borrow money for specific reasons, intending to pay it back with cash rather than with additional debt. The market is dominated by mid-size companies in a state of strategic flux, so most high yield bonds never mature, as companies are taken over and the debt is redeemed early.

Real yields on government debt are at historical lows, whereas the coupons available from high yield issuers are attractive. A yield of roughly 6 per cent from global high yield is therefore appealing and with investors being driven by the need for income, an allocation to high yield can play a major role in helping to achieve this.

The environment of low growth and low interest rates is expected to continue for some time and provides a benign default climate, with default rates continuing to fall, benefiting from a virtuous cycle of refinancing.

Azhar Hussain is head of global high yield at Royal London Asset Management