How to balance income generation and credit risk

The intuitive course of action is to have an allocation that involves taking more credit risk as the yields on such bonds are higher, and, in many cases, offer yields that are greater than the prevailing level of inflation. 

But for all that the income is higher, so the risks are higher, as they involve exposure to corporate entities at a time of deteriorating economic data.

In more normal market times, the deteriorating economic conditions would be leading to a drop in inflation, potentially making the yields on the lower-risk government bonds sufficient.

But if we have the sort of stagflationary environment that some parts of fixed income markets are presently pricing, then economic conditions could deteriorate, reducing the appeal of credit assets, but also keeping those invested in most parts of the sovereign debt market in a position whereby, if income is their focus, they are losing spending power. 

Thomas Gehlen, senior market strategist at SG Kleinwort Hambros, says that in the current economic climate, the extra yield offered by high-yield bonds does not justify the extra risk, and adds that investors would be better served, if they wish to achieve a higher income, to own income-paying equities or assets such as infrastructure. 

Robert Alster, chief investment officer at Close Brothers Asset Management, says that, "in the Close Select Fixed Income bond fund, we operate with a cautious approach: 16 per cent in government bonds; 67 per cent in investment-grade bonds; and just 13 per cent in high-yield bonds (and only in the safest “BB” part of the high-yield universe).

"This diversification allows us to boost the overall yield of the fund to 8 per cent, while maintaining a very strong average rating of the fund of BBB+. Bond funds now offer a genuine income for investors, for the first time in a generation.”

He adds: “If income is a priority for an investor, then corporate bonds remain a fundamental part of a portfolio. As government bond yields have increased significantly over the past two years, so too have corporate bond yields.

"Indeed, sterling investment-grade bonds offer yields of [around] 6.2 per cent in October 2023, while riskier sterling high-yield bonds offer yields of [around] 10.4 per cent.

"Given the general macro uncertainty, coupled with the relatively attractive ‘all in’ yields offered by government bonds, we believe that a portfolio should be well-diversified across government bonds and investment-grade bonds, with a much smaller and very selective allocation to ‘best-in-class’ high-yield bonds."

A representative of PIMCO says its base case macro outlook and projections anticipate core inflation will trend lower but remain above central bank targets for a while in some developed economies, including the US and Europe, potentially resulting in a re-acceleration in core inflation over the next few months.

They add: “With that in mind, we’ve increased credit quality in the income portfolios, while seeking ample liquidity to pursue resilience and flexibility in the face of an uncertain economic trajectory. These high-quality assets can provide compelling yields, with potential downside resilience and price appreciation should we slide into a recession.

"Our flexibility has already enabled us to take advantage of market dislocations in high-quality assets that have been caused by fear or sudden shifts in economic expectations.

"We expect volatility across the globe to continue into 2024, providing fertile ground for active managers."

One area they are finding attractive right now is in US mortgage bonds, where they feel the yields more than compensate for the extra risk involved relative to government bonds. 

If income is a priority for an investor, then corporate bonds remain a fundamental part of a portfolio.Robert Alster, Close Brothers

Brian Kloss, fixed income investor at Brandywise, disagrees. His view is, "with investment-grade bonds, one can get 7 to 8 per cent income, which is higher than the inflation rate”.

Matthew Rees, head of global bond strategies at L&G Investment Management, says in relation to high-yield bonds – that is, the highest risk end of the bond market – that the yields are now in the range of 400-450 basis points above those offered on government bonds, and he regards this as attractive because even if some of the high-yield bonds do default, the yields on offer are large enough to compensate.

He says that a feature of the high-yield market in recent years has been the migration of what he believes to be the best companies to that market, which he says now “means the US high-yield market is of higher quality than has been the case in the past”, which should mean default rates in this part of the market are lower than has historically been the case, while the current spread relative to government bonds does not, in his view, reflect this altered risk profile. 

Peter Staelens, who runs the CVC Income and Growth investment trust believes that floating rate notes represent an opportunity, as they offer yields in line with interest rates, while it is possible to own some of these type of bonds which are not excessively risky.

David Thorpe is special projects editor at FT Adviser