Is high yield an equity alternative?

On the one hand investors can participate in the ‘risk on’ trade as global investors grow in confidence, but on the other they have the relative security of a safe and less volatile yield. But do high yield bonds really represent an alternative to equities in the current climate?

On historic performance grounds, high yield certainly appears to compete with equities. In the past five years, the return on the average fund in the sterling high yield sector is 50.4 per cent. There are equity sectors that have delivered higher returns – UK, Japanese and North American smaller companies, for example – but the UK All companies and equity income sectors, global, Europe and most others are well below that level.

Equally, high yield has behaved marginally better in ‘risk off’ periods. For example, in the period from April 2008 to April 2009, the average fund in the UK sterling high yield sector fell 19.5 per cent, according to FE.

For the same period, equities saw much higher drawdowns. UK equity income is down 27.3 per cent, while Europe fell 29.9 per cent. Only North America and Japan saw lower drawdowns than high yield. This suggests that high yield – in the past five years – has fulfilled its role in the twilight zone between bonds and equities.

The overall yield on high yield bonds is still higher than it is for equities in spite of the sector’s recent strong run of performance, which has seen a significant compression in yields. The yields on individual funds in the IMA sterling high yield bond sector vary from 9 per cent to 4.6 per cent, but most yield between 5.5 per cent and 6.5 per cent.

In the UK equity income sector, some of the ‘enhanced’ income funds have yields of more than 6 per cent – the Schroder Income Maximiser, for example, has a yield of 6.9 per cent. However, the majority of mainstream UK Equity income funds yield between 3.5 per cent and 4.5 per cent. The majority of global equity income funds yield roughly 1 per cent lower.

But that is historic. The high yield bond sector has been supported by a confluence of declining government bond yields and a desire for income. The real question on high yield bonds is whether yields are supported at these levels and whether investors are likely to see a decline in capital values. Multi-managers such as Marcus Brookes, head of multi-manager at Cazenove Capital, has recently sold out of his high yield bond exposure, favouring enhanced equity funds as a source of yield. His reasoning was largely valuation-driven: high yield has had a strong run and the risks appeared greater on the downside.

High yield bonds also have the time bomb of higher interest rates with which to contend. Although high yield bonds often lag the rest of the fixed income market in reacting to higher rates, history suggests that after four or five rises, they start to fall. Even the perception that this may happen could destabilise the high yield market.

Equity income managers are nevertheless facing their own problems. Capita Registrars recently cut its forecast on UK dividend growth for 2013, after payout growth halved in the second half of 2012. However, payouts are still expected to be at the same level as last year, with sectors such as the banks increasing their payout ratios. Equally, equity valuations look more modest relative to history and therefore there remains more room for capital upside in equities.

Gavin Haynes, investment director at Whitechurch Securities, is retaining some holdings in high yield bonds, but being extremely selective: “With the economy improving, we expect default rates to remain low. We have a number of holdings in ‘conservative’ high yield funds. There is lots of new issuance and some of it is not of the highest quality. We hold the Kames High Yield Bond fund and the Axa US Short Duration High Yield bond fund. These have low volatility, low duration and interest rate risk.”

He adds: “Short duration bonds will have lower volatility than high yield bonds as a whole, and also than equities. However, the key thing is that bonds have had a spectacular run and investors are not going to receive double digit returns. They may have exceeded equity markets last year, but I wouldn’t expect that to happen again this year. Investors need to be happy with the coupon, but with interest rates likely to remain low, there is unlikely to be a significant sell-off.”

Phil Milburn, manager of the Kames High Yield Bond fund, concludes: “High yield bonds are not so much an alternative to equities, but different. They tend to have less volatility, with lower total returns over a cycle, but also lower drawdowns. With bonds, investors are higher up the capital structure, but they will be in riskier companies. They can provide a dampened version of the risk-on trade. In other words, both have a place as a source of income in a portfolio.”

Cherry Reynard is a freelance journalist