Fixed Income  

Alert sounded over high yield consensus trade

Fixed income managers have warned on high valuations in the high yield bond market that could pose challenges to strategic bond funds when interest rates rise.

Managers said the “consensus” trade to pile in to high yield bonds ignores the increasing risk from interest rate rises and the fact the bonds are pricing in a strong economic recovery that is far from certain.

Funds investing solely in high yield bonds have significantly outperformed those investing in investment-grade corporate or government bonds since the financial crisis, leading to a rise in demand from investors seeking a higher income.

Article continues after advert

The average fund in the IMA Sterling High Yield sector has delivered a return of 95.7 per cent in the past five years, compared to 52.3 per cent for the IMA Sterling Corporate Bond sector or 21.1 per cent for the IMA UK Gilts sector.

Strategic bond funds with a high weighting to the asset class have also performed well in recent years.

But the outperformance of high yield has left the asset class trading far more in line with government bonds, according to Aviva Investors’ head of high yield Todd Youngberg, thus increasing the bonds’ sensitivity to movements in interest rates.

Mr Youngberg has revised down his outlook for returns from high yield bonds, citing research showing that the average price of a high yield bond is $104 when compared with a face value of $100, meaning investors are set to lose money when the bond matures, excluding any coupons.

Bryn Jones, co-manager of the Rathbone Strategic Bond fund, said investors now face a dilemma regarding high yield allocation.

“You’re not being compensated for a rate rise, and high yield will suffer very quickly. It’s not going to happen tomorrow, but you can’t afford to be late to the party,” he said.

“There is no liquidity, and the change will be quick, so you should think about positioning portfolios now, although you could miss out on some of the carry.”

Mr Jones added that defaults are almost guaranteed when rates rise, as European companies are now more indebted than in 2008, before the financial crisis.

Nick Hayes, manager of the Axa WF Global Strategic Bonds fund, said it had become a “consensus” among strategic bond managers to have short duration, but with high exposure to credit risk in the form of high yield bonds.

He said the trade had “made a lot of money” in recent years, but that he is now “concerned with overall valuations”, and has subsequently reduced high yield exposure by 8 per cent.

Mr Hayes questioned the pricing of high yield bonds, which he said are reflecting a consistent global economic recovery.

“We could get bigger positive economic surprises, but it is more likely there will be some disappointments which will cause bond spreads to widen,” he said.

A large number of funds in the IMA Strategic Bond sector have more than 40 per cent of their assets in high yield bonds, according to data from Lipper.