High YieldApr 25 2017

Best in Class: Bright spot in a tough space

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Having enjoyed a bond bull market for – let’s face it – all of our careers, the outlook for fixed income is now uncertain to say the least. 

Government bond yields are low. Inflation is rising, bringing with it pressure for interest rate hikes, which is bad news for gilts and a lot of investment-grade bonds.

Hence the bright spot seems to be in high yield; the biggest peril in this space is not inflation or interest rate risk. Sub investment-grade companies are deemed to be too risky to be able to issue long-duration bonds, so most have a maturity of less than five years and the maximum is never likely to exceed 10. 

Instead, the bigger risk is default risk and, unlike inflation and interest rates, which are out of our control, this is the one area where fund manager skill can make a huge difference.

A fund that fits the bill nicely is Aviva Investors High Yield Bond.

Manager Chris Higham looks for sustainable income, which in the high-yield universe means avoiding the losers. This implies he has a disciplined selection process but isn’t afraid to show conviction. While there are 80-100 bonds in the portfolio, it is a lot more concentrated than most peers. 

The process starts with two scorecards. In the first, he deduces where to explore, based on the level of economic growth expected across various regions. In the second, he establishes the best sectors in which to invest within the regions identified. This results in a matrix that shows the optimal region-bond sector combination.

Mr Higham then looks for bonds he believes are underpriced by the market, with a bias towards companies with strong business positions but weak balance sheets, because he thinks they are incentivised to strengthen the balance sheet over time. 

The fund is defensively positioned at present, with an average duration of just 3.78 years.

The manager usually has a heavy focus on UK and European bonds, but currently has roughly a quarter of the fund in the US. Extended quantitative easing in Europe is keeping yields depressed – at around 3 per cent – and he believes the risks are higher due to the upcoming French, German and possibly Italian elections. 

He started allocating more money to the US last year as the market is providing double the yield at around 6 per cent. 

At the stock level, Mr Higham has been taking advantage of some legacy bonds – debt that was issued in or around the time of the financial crisis. An example is a Barclays Bank bond, due to mature in 2049 with a coupon of 14 per cent. 

It’s callable in 2019 and, while he’d love Barclays not to call it, the bank obviously will as the bonds it issues today have a coupon of just 3 per cent. But like repaying a mortgage early, there are penalties, and so while he’ll lose a high yielder, he – and the fund – will be compensated. 

This fund really speaks to the income-hungry investor and those requiring an allocation to bonds. While obviously higher risk, Mr Higham’s security-picking skill has meant that he hasn’t suffered a single default in the past three years.

Darius McDermott is managing director at FundCalibre