Climbing up the yield curve has always been an option for investors hunting for higher and higher potential income, but the commensurate risk needs to be taken into account.
But what do managers mean by a yield curve, let alone why it might be higher risk to climbing up it?
The yield curve is the term given to a graph that plots the rise and fall of the yield of fixed-interest securities, when plotted against their duration - in other words, the length of time they have to run to maturity.
For example, the longer the date of the bond (the length of time an investor must hold it to maturity), the likelihood the higher the potential coupon (or yield) might be - unless you're holding UK gilts, which at the moment look less attractive the further out you go.
According to the Bank of England's latest implied forward curve, investors will not be compensated for holding onto their gilts after 10 years.
That said, given recent downward trends, investors do not seem to be compensated at all for buying UK gilts - it's all in negative territory.
So investors seeking higher yields often start 'going up the yield curve' - hunting for higher yields from higher-risk bonds than UK gilts.
Gilts are perceived as ultra low-risk as the government promises to pay out on maturity - as long as the UK is not at risk of default.
Incidentally, M&G Investments' Bond Vigilantes cite a strong track record for the UK, which has not had a formal default, although in 1932, in the grip of the Great Depression, Britain (and France) defaulted on First World War debt to the United States. This was the inter-allied debt which the Vigilantes wrote about in their 2010 blog.
Although the UK lost its AAA-rating shortly after the vote to leave the European Union, it is still considered to be a low-risk, high-quality sovereign debt issuer.
By buying lower-grade debt - B, CCC, or lower, the yields get commensurately higher - but so do the risks.
For example, the Greek 10-year government bond reached an all-time yield high of 48.60 in March of 2012 and a record low of 3.21 in June of 2005. Its current yield of 6.96 as of Friday January 13 may seem more attractive than UK gilts, but the risk is - well, it's Greece. There's economic risk, political risk, inflation risk, interest rate risk....
Investors may therefore decide to head away from sovereign (country) debt and head to the corporate bond market. Again, AAA is the highest rating (and rare at the moment). As an aside, Lehman Brothers had been AAA-rated just before it crashed out of history, so nothing is guaranteed.
Rather than just looking at high-yielding assets, the best approach for most people is to focus first and foremost on long-term asset allocation. Patrick ConnollyWhile AAA-rated corporate bonds (of which there are few globally) are expected to offer a yield in excess of the sovereign debt yield, spreads have tightened recently so there is often just 1 percentage point or less in it.
The lower-rated the corporate, the higher the expected risk and therefore the investor should be compensated by a higher rate of return. That's the theory.
Investors can also go long on duration in expectation of a higher coupon, although this comes with all sorts of risk in terms of price, liquidity or inflation risk - or even the risk of default.
HM Treasury's High Quality Market corporate bond yields gives an indication of the movement of yields on the HQM corporate bond index (used as a reference point by pension funds), noting the post-Brexit vote dip during the summer of 2016.
HQM Corporate Bond Yield Curve Spot Rates
Managers do not think it is a good idea to go too far up the yield curve, or slink off to riskier geographies or go long in duration (whether in sovereign or corporate debt), despite the potentially higher coupons these higher risks might proffer.
Adrian Hull, senior fixed income product specialist from Kames Capital, explains: "Both index-linked gilts and CCC high yield markets have represented the extremes of chasing yield and returns in 2016.
"Index-linked bonds represent the highest duration assets available, and the roller-coaster ride shows the potential for gain and loss. It's not for the faint-hearted.
"In a similar vein, the higher rally in the weakest high yield credits has been primarily driven by a bounce and subsequent stability in the oil price. Again, for investors in that sector since 2014, it has been a roller coaster.
"These opportunities can provide double-digit returns but is entwined with significant risk and volatility. While it is reasonable to nudge risk budgets higher - perhaps look at BB credits and 10-year rather than five-year bonds - it is a little less clear that the solution is to embrace fully the riskiest assets."
Advisers' view
His comments have been matched by those of financial advisers.
Darius McDermott, managing director of Chelsea Financial Services, comments: "Investors have been pushed further and further up the risk spectrum since interest rates were lowered to emergency levels almost eight years ago."
Patrick Connolly, certified financial planner for Chase de Vere, says chasing yield is a decision an income investor will have to make, taking into consideration the level of income they actually need, and the amount of risk they are prepared to take to achieve it.
He says: "In the current environment, many people are having to make compromises between these areas, which means they have to accept a lower level of income or more risk than they ideally want."
However, Mr McDermott does not believe investors have to go into high yield or junk bonds necessarily to get decent yields.
He highlights some funds marked out by Chelsea Financial Services as offering decent single-digit yields without presenting too big a "roller-coaster risk":
"It is still possible to get mid-single digit yields without risking everything," he says.
"Funds like Jupiter Strategic Bond (4.7 per cent), Invesco Perpetual Monthly Income Plus (5.45 per cent) and M&G Optimal Income (4 per cent) all offer a decent level of yield and are not funds I would put at the riskiest end of the fixed income spectrum by any means."
Mr McDermott adds: "None of the funds mentioned above are in the high yield sector and are all paying mid-single digits.
"If you go any higher, you are looking at emerging market debt - Aberdeen Emerging Markets Bond offers 6.2 per cent yield, for example.
"I'm not sure going from a strategic bond to an emerging market bond for just 1 per cent to 2 per cent more yield will be seen as worth it for most investors though, only those willing to diversify their exposure more on the periphery of their core portfolios."
Mr Connolly agrees there's no need to make a jump into high-yield territory as the first port of call. He explains: "Rather than just looking at high-yielding assets, the best approach for most people is to focus first and foremost on long-term asset allocation.
"It is important to get the asset allocation right. If this does not generate enough natural income, then investors can top this up by making capital withdrawals, although the higher the level of withdrawals, the less sustainable and the more the capital will be eroded."
simoney.kyriakou@ft.com
