Just as potential Isa sales were looking at their most overcast, the high-yield bond market has returned more than 11% in a single quarter. Today's economic climate presents good opportunities for investors
We are now well into the Isa season and it is unfortunate that most Isa investors have yet to experience a positive return from the equity markets.
With this in mind, much IFA money will surely be pointing toward the bond market. According to the latest figures issued by the IMA, the UK corporate bond sector was the only major asset class to make a positive return for investors last year.
The average return of about 3.5%, which resulted from the boom in the investment grade end of the market, may not look much but in the current environment I can't see anyone complaining about actually making it into positive territory.
This is especially the case when, according to the IMA, the average UK All Companies fund would have cost investors about 26% and the average UK equity income fund, despite the fanfare the sector has received, would have cost almost 23%.
Of course, there is always the risk at this time of year that recent performance can unduly influence investment choices and this year is no different.
Those expecting the UK corporate bond sector to replicate last year's performance should think again. The majority of funds here are composed of investment-grade bonds and, while these enjoyed a significant rally as investors ran for cover last year, the cycle has since moved on. A clear indication of this and investors' increasing risk appetite is the fact that the Merrill Lynch High-Yield Index has returned roughly 11% over the last quarter alone.
However, unlike previous years where former winners such as TMT, biotech or even zeros drew such attention only to disappoint in the most spectacular fashion, the potential for pure bond funds to 'blow up' is far more limited.
Bond funds will probably not be the outright best performers in 2003. That particular plaudit will likely go to something exotic such as Korean or Russian equity funds. But who in their right mind will want to take this sort of gamble when a well-managed bond fund is likely to produce better returns than a standard equity fund and for less risk?
Of course, the change of environment from one that favours investment grade to one which favours high-yield is something we have been trying to draw attention to for some time.
In October last year, we made a great effort to alert both IFAs and the national press that, in our opinion, the bull run enjoyed by investment grade bonds had come to an end.
Terrorist attacks, the threat of war in the Gulf, an epidemic of corporate frauds, not to mention more mundane influences such as the worst equity markets for a generation, all combined to push investors toward the safety of the investment grade market. We felt the growth in capital values in the investment grade sector had all but topped out, as was evidenced by the lowest gilt yields for almost 40 years (see top chart).
It is falling interest rates that generate real growth for investment grade bonds and that is what prompted our October warning on the asset class. Our feeling was that rates had reached their natural floor and that there simply was not enough bad news left in the system to justify continued price growth.
As a result we warned anyone who would listen not to 'miss the next bond bubble', which we forecast as being in high-yield bonds. We were not far wrong. Since the middle of October, when the US market commenced a technical rally, the high-yield market has rallied by more than 11%, equating to an eye-watering annualised return of more than 40%.
As always, it is difficult not to get excited by figures such as these but it is important to remember just how skewed this index has been as a result of all the 'fallen angels' that have taken up residency there. Since suffering a credit rating downgrade, Alcatel alone now accounts for some 10% of the index. Similarly, car giant Fiat, upon entering the high-yield market recently, immediately took up an index weighting of close to 18%. Add to that the presence of former blue chips such as Ericsson and Tyco, and you start to get a better picture. Even so, it is 'cross-over' names like these that have lit up this sector over the last quarter.
A more reliable index for our purposes is probably the Merrill Lynch Constrained Index, which puts a cap on the proportion one bond can contribute to the index. Even so, this more restrained index has returned 7.6% (on a price return basis) since the middle of October, equating to an annualised return in the region of 30%.
That does not mean to say there are not some potential risks awaiting the high-yield market, we could still see high-profile downgrades in the sector contaminating sentiment. For example, if a major issuer such as Ford were to be downgraded further than the market expects, it could spark the sort of run for cover that has made investors previously think twice about high-yield bonds. That is why funds with combined portfolios of investment grade and high-yield bonds are so well-positioned for the current environment.
It is a long time since advisers have had a real 'best of both worlds' option, but that is exactly what today's economic climate is presenting to bond investors.
Those new names to the sector can be neatly placed into one of two groups. The first group is the already mentioned 'fallen angels'. These mostly found themselves in the ranks of the sub-investment grade as a result of credit downgrades in today's harsh operating environment. Consequently, they represent some of the largest companies ever to have high-yield bonds in circulation.
This, and their fervent wish to pay down their debts (often through equity issuance) and re-enter the ranks of the investment grade sector, is what accounts for their recent performance.
Although we have seen a number of high-profile new equity issues aimed at de-levering debt-laden balance sheets, it is something of which we can expect to see a lot more as the rigours of bondholder value continue to demand less company gearing.
That members of the other group of new bond issuers have virtually nothing in common is probably the key trait that they share.
Issuers such as packaging giant Smurfit, European chemical conglomerate Kronos, telephone directories publisher Yell, French housebuilder Kaufman & Broad and Swedish media outfit ProSieben have all come to market recently. The reason for such activity is that now is one of the most attractive times in the past three years for companies with sound balance sheets to actually issue more debt. Certainly, early buyers have been rewarded for their optimism, although it has really been the resurgence of telecoms issues that have been the story in the high-yield market.
This is mainly because it was these companies that were first to face the music when the TMT sector as a whole began to crumble. The rally in telecoms companies began as early as late summer as having been the among the first to de-lever and they were in prime position to benefit from improving risk aversion. That is why we have remained overweight in the sector. Similarly, old favourites of ours such as the consumer stocks Gala Bingo or WeightWatchers were also among the first to benefit as a result of their relative transparency and strong cash generating credentials.
The question from here is, with such a recent surge in high-yield performance, how long can we expect the sector to continue its run of outperformance?
In my view, the current rally could well continue until the second half of the year based on historical analysis. Even allowing for the recent spree, the spread between the yields on offer from investment grade and those in the high-yield market are still wider than they were only two years ago (see bottom chart). While we might expect a degree of profit-taking from here which could reduce this differential, there is still the time and opportunity for investors to make significant gains from such issues.
There is more appetite for higher yielding debt.
Risk of high-profile downgrades is damaging sentiment.
Current rally could continue into second half of the year.
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Square Mile’s series of informal interviews
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£80bn funds under calculation