High yield offers the best potential in bonds but careful stock selection is key to hunting down the compelling returns available. Rayner Spencer Mills' Ken Rayner explains.
Sterling high yield bond funds are defined as those which invest at least 80% of their assets in sterling denominated (or hedged back to sterling) below BBB minus fixed interest securities (as measured by Standard and Poor’s or an equivalent external rating agency). This includes unrated bonds but excludes convertibles, preference shares and permanent interest-bearing shares.
The core areas for investment in fixed interest are government debt and corporate debt, with the latter split between investment grade and high yield. Other options also include emerging market debt and inflation linked bonds.
Ebbs and flows
The last decade has seen high levels of market volatility and, in particular, since 2008, a bull market in government bonds until 2013. Considerable macro uncertainty remains over the path of the economic recovery but the most likely scenario for growth is that it continues at a rate which, in many economies, will appear tepid, with ebbs and flows.
Is this the fixed income market’s bright spot?
With growth at a low level, any slowdown will invariably provoke fears of a renewed recession. Investors should remember that this type of sluggish economic recovery is actually typical of economic recoveries post-major banking crises. As long as commodity prices remain under control, this should be accompanied by low inflation and low interest rates.
The fundamental outlook for fixed interest markets is little changed over recent months. Over the medium term, core government bond markets are likely to see continued upward pressure on yields as long as the economic recovery continues as expected.
There will, of course, be trading rallies in the market from time to time. There is now less uncertainty about the US fiscal cliff and debt burden although, with inflation still very low, the government still faces hurdles in getting the debt lower. The recent taper announcement has been received well by markets, as its association to tighter monetary policy has been carefully distanced by the central bank.
Short-term interest rates appear likely to be anchored at current levels for some time to come - even the States is some way off actually raising rates. The economic recovery in the US is gaining pace but inflation pressures remain benign, so there is unlikely to be any rapid or major tightening of policy as occurred in 1994.
Monetary policy has already been tightened at the long end of the yield curve, as seen in the increase in US mortgage interest rates. This may actually put off the necessity for the Federal Reserve to raise short-term interest rates. Mortgage costs are already over 100bps higher than before the Fed began talk of tapering in late May.
Returns from credit look likely to outpace those from government bonds, although returns here are unlikely to be exciting over the medium term. As the recovery gathers pace, there is still scope for credit spreads to tighten a little further in high yield compared to government bonds.
Bond markets are still supported strongly in some areas despite this environment and investment grade credit continues to see strong demand from institutional investors, such as pension funds, that wish to match liabilities.
High yield is an area that has continued to do well relative to other areas thanks to spread opportunities and the risk premium for holding lower grade debt. Within high yield, strong stock picking will remain necessary, as managers need to focus on names where default risk is wrongly priced by the market.
Many high yield names have short duration, so the asset class can have low duration or interest rate risk. High yield bonds continue to offer the best potential in fixed interest, although this opportunity has also reduced in recent weeks.
There has been some evidence of overheating, with lower quality issues coming to the market. These have been turned down by many of the top investors in this asset class.
The increase in spreads has brought valuations to much more interesting levels, with an attractive income available of around 7% from high yield bonds. Once again, in a low rate world, this level of yield - if sustainable - is likely to prove compelling.
Investors should remember this is not a normal business cycle recovery. Exceptional measures have had to be taken to offset the effects of the de-leveraging associated with the global financial crisis.
Although we are now close to the point where adjustments to some of these policies are being made, monetary policy is likely to remain extremely loose by historic standards for a number of years to come.
It seems there is a consensus that there are far fewer opportunities to make returns in 2014 than there has been in the previous two years. High yield offers the best of these.
Rayner Spencer Mills’ top sterling high yield bond funds
IMA Sterling High Yield
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