In the second of a short series from the Baring Multi-Asset Group on opportunities in the current ultra-low interest rate environment, Michael Jervis (pictured) talks through the attractions of US high-yield bonds
As we discussed in our first article on US inflation-linked bonds, ultra-low interest rates are not going away. The combination of subdued economic growth and central bank policy has driven down yields of developed government bonds to historical lows. Currently, more than $10 trillion (£7.65 trillion) of government bonds are trading with negative yields.
One area that continues to offer investors some yield is the US high-yield bond market. Here, investors can still pocket a yield in excess of 6% - not bad in today's yield starved environment.
The major risk to our view would be the economy freezing over and default rates increasing. However, we believe the US economic picture is looking benign, with growth ticking along nicely. This should help keep defaults rates low.
Any investment in high-yield bonds is subject to the risk of corporate defaults. To get a handle on the impact of this, our 10-year forecasting process makes an explicit allowance for these defaults. This long-term approach suggests returns of around 4.5% per annum for the next 10 years, after defaults are factored in.
This may not sound like much, but in a world where cheap assets are hard to find, gaining exposure to one that is not overtly expensive is certainly a good start. Furthermore, if we are right about the benign economic cycle, defaults over the next one to two years should come in even lower than we have assumed, creating further upside potential.
A second major risk would be the US Federal Reserve changing its tone and starting to hike interest rates aggressively. We do not believe this is likely, for the reasons highlighted in the first article in this series. This is almost the goldilocks zone for US high-yield. An economy that is not hot enough to generate aggressive rate hikes, but not cold enough to generate defaults.
One worry for some investors is the relationship between the US high-yield market and US shale energy companies, which are suffering from the low oil price. Indeed, the US high-yield market does have a 15% energy-related component - and much of this is linked to the fortunes of the shale names.
While it is true some US energy companies overstretched themselves over the past few years, however, much of these past excesses have now been shaken out of the market. In 2016 we have already seen a number of high-profile defaults, including Chesapeake and Sandridge Energy. We believe the worst is likely behind us.
Nevertheless, we can strip out the apparent cheapness that is associated with the energy component of the US high-yield market, and focus only on the remaining 85%. If we do this, the yield on offer is still attractive - in excess of 6%, it is only slightly less than the total market. In other words, the value in the US high-yield market is much broader based than just the energy sector.
A common criticism of the US high-yield market is that it is overleveraged. As the market cycle develops further, this critique will become more valid, but right now we do not believe this is true. In fact, leverage levels are only modestly creeping up. Adjusting the level of spreads for the slight change in leverage does not yet raise alarm bells.
Investing with conviction
We are very much alive to the risks of investing in the US high-yield market, but believe they are overstated by the market. Indeed, in this ultra-low interest rate environment, our analysis suggests the market is attractive, because:
* Higher-yielding bonds will become increasingly favourable the longer ultra-low interest rates persist.
* The US economic recovery is healthy. It is strong enough to keep default levels modest, but gradual enough not to create inflation.
* High-yield spreads remain above their historical levels - even when adjusted for leverage or after stripping out the energy component.
Against this backdrop, and in a world of ultra-low interest rates, a yield of more than 6%, and a total return expectation of around 4.5% when defaults are allowed for, is a very attractive proposition. All of which should explain why, in the Baring Dynamic Asset Allocation and Multi-Asset Funds, we have allocated more than 20% to US high-yield bonds.
Michael Jervis is an investment manager in the Baring Multi Asset Group
The chairman worries about finance getting in touch with its feelings
Cost of acquisition: £31m
Greg Camm temporary replacement
Plan ahead … do not rush
Adviser use of social media on the up