Your IndustryApr 29 2013

High yield bonds - April 2013

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CPD
Approx.60min

    High yield bonds - April 2013

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      CPD
      Approx.60min
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      Introduction

      By Cherry Reynard
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      However, with yields on government and high quality corporate bonds at record lows, investors are becoming more selective. The chief beneficiary of the continued appetite for fixed income has been high yield bonds.

      Fund flow data from EPFR Global shows emerging markets, high-yield and floating-rate bond funds each took in more than $850m (£557.2m) in the first week in April. The group attributed this to the continued pursuit of yield, in spite of geopolitical and macroeconomic risks. Phil Milburn, manager of the Kames High Yield bond fund, says: “Net flows into high yield bonds are still positive. There is lots of cash around and many funds still have cash to spend for the right opportunities.”

      The popularity of high yield bonds is not surprising. They were one of the top-performing asset classes in 2012, with the average fund returning 19.3 per cent. Their performance has waned a little in 2013, with the average fund up just 2.8 per cent for the year – in line with the UK Sterling Corporate bond sector, but to many they offer the chance to participate in the ‘risk-on’ trade in markets while gathering a high and stable yield.

      In spite of their recent strong run, the yield on high yield bonds remains attractive. The 10-year UK government bond is paying 1.71 per cent. High grade corporate bonds also had a spectacular year in 2012, up an average of 13 per cent, which has compressed yields to historic lows with the median fund in the sector now yielding less than 4 per cent. In contrast, high yield bond funds are still yielding between 5 per cent and 7 per cent. This also compares favourably with other sources of income such as equities.

      Equally, default rates are not worrying, in spite of the difficult economic climate. Alan Higgins, UK chief investment officer at Coutts, says: “High-yield bonds, whose yield spreads over government bonds are near their long-term historical average, continue to compensate investors sufficiently for the greater default risk taken on. Default rates for high-yield are currently low by historical standards, while volatility in the sector is also at low levels.”

      Mr Milburn admits that spreads above government bonds are a little lower than their long-term average, but then the default rate is also lower than its long-term average. He adds: “Jim Reid at Deutsche Bank in his annual default study suggested that investors are compensated for the default risk in high yield bonds. The overall yield looks poor relative to history, but then it does for the whole of fixed income.”

      High yield bonds also offer greater protection against interest rate rises. Although most analysts believe that any substantive rise in interest rates is way off, the expectation of interest rates rises could cause a sell-off in parts of the bond market and an erosion in capital values.

      To move into short-dated bonds is one option, but investors have to sacrifice yield. High yield bonds are less sensitive to interest rate movement because there is more credit risk included in the price. Mr Higgins says this is a key benefit in the current environment, where yields are more likely to rise than fall.

      Mr Milburn adds: “High yield has historically had a small negative correlation to the US treasury market. This is intuitively right – the type of environment that is good for high yield – economic growth and inflation – is bad for the treasury market.”

      However, in the longer-term high yield bond performance is dented by rising interest rates, but Mr Milburn says that they hit high yield later in the cycle.

      These are all sound reasons why the high yield market has retained its popularity. However, there are still some reasons to be cautious. Although issuance has been buoyant since the start of the year, Mr Milburn says that the quality of that issuance has fallen. This is seen less in the type of companies coming to market and more in the covenants that are attached to the bonds, which offer less in the way of investor protection.

      Equally, high yield bonds look attractive, there is less prospect of rises in capital values for the sector after the strong performance in 2013. Even though the sector is less vulnerable to interest rate rises and a rise in the default rate (which could push capital values lower) is also unlikely in the medium term, it is difficult to see a catalyst to push capital values higher either. Investors are likely to receive the coupon and little else.

      The attraction of high yield in the current environment as a safer way to play the ‘risk on’ trade and a means to generate a higher, less volatile income stream is clear. Yet the sector’s salad days may be behind it and, while the yield remains attractive, double-digit capital returns are unlikely.

      Cherry Reynard is a freelance journalist