With today's high-yield credit market exceeding $500bn and comprising issuers from almost every industry, advisers are beginning to realise the worth of so-called junk bonds
High-yield bonds may have been unfortunate enough to have been branded junk bonds but advisers are increasingly realising that they are anything but rubbish.
Today's market exceeds $500bn and includes issuers from almost every industry. The sales of high-yield corporate bond funds have also risen significantly as today's low inflation/low interest rate environment continues to force the migration of deposit investors to more attractive pastures.
While high-yield bonds are obviously riskier than investment grade, they compensate investors by offering far more attractive levels of yield. This means that successful fund management in this market is all about knowing the individual company stories. Of course, this can be very time intensive but it is well worth the effort.
It is already a well-publicised fact that when examined over virtually any time frame, high-yield bonds offer the single highest level of return per unit of risk of any asset class.
Despite the long shadow cast by the early excesses of the US high-yield sector, corporate bonds have come a long way in the last decade. Figure 1 demonstrates that advisers who put their faith ' and their clients ' into bond funds over the last 10 years will be feeling very pleased with themselves right now.
This recent outperformance of bonds and the promise of more to come, means that many advisers are now waking up to the high-yield story. Kerry Nelson, associate director of Deep Blue Financial Services, believes high-yield bond funds Isas are likely to be one of the few really big sellers this season.
'While individual junk bonds would be totally inappropriate for most private investors,' she says, 'it is amazing how low the risk profile goes once they are pooled. What advisers need to look for is a well-diversified portfolio with a manager who can demonstrate the ability to prosper in a turbulent market.'
Nelson also points out that bond funds have a natural edge over equity investments. 'It is worth remembering,' she says, 'that income distributions from a corporate bond Isa carry a 20% tax credit compared to the 10% credit for equity investments (due to be withdrawn in 2004). This means that equity funds are already at a disadvantage in terms of total returns before a penny is even invested.'
Of course, any observer of the high-yield bond market will have more than a passing interest in current default rates. The truth however, is that they have rarely been higher.
The major market correction at the start of 2000 meant that it has not been plain sailing for any asset class in recent times, while the events of 11 September naturally pushed back expectations of when things might improve. But rising default rates need not necessarily be a cause for concern.
Advisers who may be cautious about this market need to keep in mind that while default rates slowly tick up, the peak in default rates has historically been a very reliable lagging indicator. This literally means that the best time to buy has always been while default rates are on the rise.
The most important point to make though is to underline the importance of strong stock selection on the part of fund managers. Even with defaults running at over 10%, there is no reason to assume that a good fund manager will fall prey to a defaulting bond.
By the time default rates start to migrate back toward their historic average of around 3.5% a year, probably around the middle of this year, the best of the returns will already have been made for investors.
Bond markets have already been moving steadily in response to improving investor sentiment. Because the R&SA Extra Income Bond fund is 50% investment grade and 50% high-yield as opposed to the Maximum Income Bond Fund which is entirely high-yield, an illustration of their recent performance [see Figure 2] clearly demonstrates the recent swings in bond market sentiment. As can bee seen, although the high-yield market made strong returns in the first half of last year, it had started to drift lower by the third quarter. Even so, they were still far superior to those returns on offer from the FTSE All-Share.
It is also apparent how investors began to return to the high-yield end of the market around November of last year, once again lifting the performance of both funds. We expect to see this trend continuing and with investment grade bonds now fully valued we should see the 100% high-yield portfolio start to outperform again later in the year.
Despite short-term volatility in the sector, this year looks likely to be the year of the bounce for high-yield bonds. As a result, we expect to see company issuance also start to rise once more.
Apart from corporate issues such as United Biscuits, AES Corporation or Energis, we like the look of emerging market sovereign debt but, as always, it has to be the right emerging market. Unsurprisingly, investors had no appetite for risk last year but this year it is a different story. Argentine debt, for example, clearly has a health warning on the label but that has been a great benefit to markets such as Brazil.
In fact the last time these bonds looked so attractive was during the last recession where they were producing annual returns of around 25%.
While high-yield bonds are obviously more risky than investment grade, they compensate investors by offering far more attractive yields.
Income distributions from a corporate bond Isa carry a 20% tax credit.
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