European market participants increasingly view high yield as a well-established asset class. It has become an integral part of many institutional investors’ strategic allocations to fixed income. As the market is maturing, it is transforming into a fully-fledged component of the global fixed income universe and its diversification and liquidity have improved.
Consequently it has become an increasingly attractive option for income-seeking investors from around the globe and the likely target of new capital inflows from global fixed-income funds.
Historically investors have viewed high yield as part of a fixed-income allocation, but in reality the behaviour of high-yield bonds has not followed other fixed-income sectors as closely as you might imagine.
Based on statistics provided by Bank of America Merrill Lynch Global Research, looking back at three decades the correlation of high-yield bonds with investment-grade bonds has been surprisingly low at just 0.3. By comparison the correlation with US stocks has been 0.56 so it turns out that, historically, high-yield bonds have tracked stocks more closely than they have tracked apparently more comparable investment-grade bonds.
The returns of high-yield corporate bonds, such as equities, are strongly linked to the business results and fundamentals of the underlying companies. High-yield bonds tend to outperform investment-grade bonds when interest rates rise because interest rates usually rise when business conditions are strong – in fact they are typically insensitive to interest rate movements.
Indeed US high-yield bonds have a negative correlation with 10-year US Treasuries in the long term, again based on BofAML Global Research’s analysis.
The same research shows that, from a volatility perspective, high-yield assets have shown half as much volatility as equities while being fundamentally less risky because bondholders get paid before shareholders if the company declares bankruptcy.
Of course this does not mean that the asset class is immune from bouts of volatility and illiquidity. Markets become dislocated in times of fear or panic and investors need to be prepared for the impact of mark-to-market risk on their capital values.
Transacting during periods of market stress can be very difficult and the general rule of thumb is that you should only buy bonds that you are happy to hold through an effective market shutdown. The ability to take a long-term view is essential.
Many high-yield investors are interested not only in attractive yields, but also in the potential for capital gain that can result from positive credit events. Indeed ‘event-driven’ credit investing has one of the best risk/return profiles for the medium to long term. Such managers invest in the debt of companies where there is a high probability of a positive credit event occurring that triggers a re-rating or a refinancing of the debt, providing a capital gain. While waiting for the event, they collect an attractive running yield from the coupon payments.