Are high yield bonds a risk worth taking?

Graham Duce, co-head of multi-manager funds at Aberdeen Asset Management, explains that after seeing “fantastic returns” from high yield bonds he has now largely sold out of the asset class as he believes “past levels of returns are no longer achievable”.

“My concern is that liquidity constraints will be really tough for managers, and also that pricing of recent issuance has been opportunistic given the amount of money that has gone into the asset class,” he says.

Mr Duce adds that after the panic generated by the Cyprus bank crises, further market uncertainty could see yields widen, as high yield is more volatile than other areas of fixed income. But the manager believes investors’ demand for income will continue to sustain the market for high yield.

Researchers at S&P Capital IQ found that investors were flocking to high yield in spite of evidence that returns are diminishing.

Analysts Gustavo Tella, Claudia Holm and Kateryna Lipatova note that in the year to January, yields on European non-investment grade corporate debt have been decreasing by an average of 5 per cent, with European high-yield bond spreads tightening by an average of 4.7 per cent against 10-year German government bonds.

These lowered returns are set against a backdrop of rising risk, with probabilities of European default doubling in the past year.

Looking at other regions of the market, Deutsche Bank strategists Jim Reid and Nick Burns say that US high yield is trading at a record low, just four year and a half years after trading at an all time high of roughly 20 per cent.

The strategists believe that the “artificially high demand for fixed income will continue for some time and as such the default rate will stay artificially low”. This finding is in keeping with financial advisers, who say they are still seeing the demand from clients for below investment-grade debt.

Ben Seager-Scott, senior research analyst at Bestinvest, warns investors to be aware of the growing risks associated with high-yield.

“The big worry is when you look across the whole market and it has been distorted by investors chasing yield by diving into investment grade corporate debt and strategic and high yield bonds, putting them at risk of moving down the credit quality spectrum,” he says.

Among analysts and advisers, there was one element they all agreed on – while the level of income generated by high yield bonds still remains attractive, strategic bonds can be more dynamic in their exposure.

Eleanor Lawrie is news reporter at Investment Adviser