They will always be ‘junk’ to some investors, but high-yield bonds have achieved stellar returns in recent years thanks to improving company fundamentals, the return of economic growth and a persistent demand for income.
Indeed, in August 2017, TwentyFour Asset Management noted that high-yield credit spreads – the difference between the yields offered by these instruments and those offered on government bonds – had generally fallen to lows not seen since the financial crisis.
The fund house attributed this development to “the continued hunt for yield, the absence of negative surprises, and confidence in the co-ordinated global recovery”.
The picture is similar when comparing high yield with investment-grade bonds – company debt that is viewed as less risky by investors. Robin Kyle, an investment manager at Tcam, notes the spread between these two types of debt has “come right in” over the past two years.
He explains: “High yield has been a relatively attractive play across the past couple of years. The impact of quantitative easing and the [monetary] easing cycle took longer to come through in credit spreads than in equity prices. It has [now] narrowed pretty materially.”
These bonds have also performed well on an absolute basis, with the Bloomberg Barclays Global High Yield index gaining just under 23.5 per cent in sterling terms over a two-year period. This is all good news for those who have included high yield in portfolios already. But has the opportunity passed for prospective buyers?
Tighter spreads suggest capital gains have been made by existing investors, but they also indicate buyers are now receiving less compensation for taking the risk of buying high yield as opposed to a ‘safer’ fixed income investment.
“In general, they look expensive,” warns Rory McPherson, of discretionary management firm Psigma.
He echoes TwentyFour’s point: “The extra return [achieved] from owning them over a similar maturity government bond is pretty close to its post-global financial crisis lows. This strikes an immediate note of caution.”
High yield has certainly reached some worrying extremes. Last year Bank of America Merrill Lynch noted that debt in Europe had rallied so much it had begun to yield less than equities in the region.
There are other challenges, too. Specialists have warned that covenants, or the terms of agreement between an issuer of debt and the lender, have been growing weaker in the high-yield space as issues take advantage of strong demand. This leaves investors with less favourable terms for their investments. Thus there may be reasons to fret before investors even consider broader worries about markets.
With economies performing well, central banks are looking to gradually tighten monetary policy. This could represent a double whammy for high-yield investors. Bonds tend to perform badly as interest rates rise because their yields look less attractive. At the same time, high-yield bonds specifically are closely correlated to equities, which could suffer as monetary stimulus is withdrawn.
“It will take a while for that [tightening] to happen, but high yield will be vulnerable,” says Mr Kyle.