High yield bonds have been far from immune to the sell-off in fixed income assets. Stefan Isaacs, manager of the M&G High Yield Corporate Bond fund, assesses the future for the asset class.
In a world of record low interest rates, investors are faced with a diminishing menu of options capable of delivering positive real returns after inflation. Consequently, we are all forced to consider new areas of the market in order to generate higher levels of income for our portfolios.
With valuations in high yield bonds at unprecedented levels, we believe investors need to pay close attention to the underlying forces driving these markets and maintain a flexible approach. As prices are not always justified by economic and credit fundamentals, it will become increasingly important to invest very selectively.
The dynamics affecting high yield bonds come from two opposing forces. On the one hand, the relatively weak economic fundamentals, especially in Europe, are being felt by many of the companies that issue them.
What the future holds for high yield bonds
On the other hand, the cumulative impact of injections of fresh liquidity into the global financial system from central banks provides very strong technical support.
Until short-term interest rates begin to rise meaningfully, the high yield market will continue to benefit from investors seeking positive real yields. While we expect US rates to rise in the medium term, probably as early as mid-2014, the recent figures on European growth are likely to force the European Central Bank to remain accommodative for longer.
The injection of liquidity has also had a big impact on default rates, which remain well below historic levels. What we are seeing in today’s environment is that it is actually quite difficult for a company to default. With interest rates low, running a high debt burden becomes easier to do and, with a bond market hungry for issuance, companies are able to move their liabilities to longer maturities.
Investor sentiment dipped towards the end of May as investors became increasingly concerned about a potential winding down of the Federal Reserve’s $85bn-a-month bond-buying programme.
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