In the current market climate, argues Darius McDermott, high risk bonds could represent good value despite the risks associated with the assets...
In April we were talking about corporate bonds being the opportunity of the century as markets looked to recalibrate because of the impact of Covid-19.
Since then, credit markets have recovered nicely from their lows, so is the opportunity still available to investors? With the trinity of central banks (Bank of England, European Central Bank, and US Federal Reserve) still supporting the market by buying both higher quality and some weaker high yield borrowers, and most companies looking to shore-up their balance sheets rather than pay money back to shareholders in the form of dividends, many believe it is.
There are several factors supporting the case for high yield bonds at the moment, the most obvious of which is what we've seen in the equity space where companies can't pay a dividend - or in some cases are being prevented from paying one - with investors desperate to seek out alternative sources of income.
There's always been an element of fear surrounding the high yield bond space, given the threat of defaults, but the impression I get from the managers we have spoken to is that the there are opportunities for cyclicals and what is perceived to be ‘riskier' debt to outperform from this point.
Prior to the sell-off, Aviva Investors High Yield Bond fund manager Chris Higham was bullish on the outlook for high yield in the next decade. He believes the impact of Covid-19 has bolstered his outlook - adding that high yield bond issuance has continued unabated in recent months, with almost $40bn in May to add to the $36bn in April, on top of the anticipation default rates will likely be lower than current expectations.
What does the opportunity look like?
Another benefit is that the Federal Reserve has committed itself to buying both investment grade and some high yield issues, and there has also been some pressure applied on the rating agencies to not downgrade companies that are struggling due to the pandemic.
The coronavirus and low oil prices have led to a surge in ‘fallen angels' - companies downgraded from investment grade to sub-investment grade - among them well-known names such as Ford, Kraft Heinz, Renault and Marks & Spencer.
We saw some $100bn in new fallen angels in the high yield market through to the end of April 2020 and I think we can expect much more in the next few months - despite the aid being offered by central banks - as more negative data hits sentiment. Putting this in context, we saw $164bn of new fallen angels during the Great Financial Crisis of 2008-09.
To be clear, this is not without risk. As M&G points out, the risk of a fallen angel defaulting is initially higher than it is for those already sitting in the high yield space. However, after a year or so, a fallen angel has a higher chance of becoming a rising star and returning to investment grade - this is aided by certain characteristics, such as size and industry type, required for an investment grade rating that other high yield issuers lack.
The challenge investors may well face is that a number of fallen angels have actually been offered something of a security blanket from central banks in terms of funding - could we see a number of these businesses facing similar challenges as their models were already failing pre-Covid?
That's where active management really plays its role in finding companies that can adapt, picking the winners and losers from sectors which are in the eye of the storm - like airlines for example. Baillie Gifford High Yield Bond fund manager Lucy Isles says she always looks for companies that can adapt and thrive in any environment - but that the current situation is unprecedented - pointing to viable businesses that are struggling for sales, burning cash and taking on more debt in order to comply with lockdown.
She says there is incredible value in the market and is currently looking at how companies can operate sustainably in the ‘new normal' post-coronavirus. Recent additions include Carnival, the cruise ship operator, which issued a short-dated bond with a 11.5% yield.
Having recorded high single digit returns (8.7%) in the 12 months prior to the onset of the sell-off, there was an argument that the easy money had been made for investors in an asset class that was very much ‘off-radar'. It seems another opportunity has quickly become available to investors but, on this occasion, they must tread more carefully as certain sectors will be fraught with more dangers than others.
Investors who may want access to a pure high yield fund may like the Baillie Gifford or Aviva high yield strategies already mentioned, or Man GLG High Yield Opportunities. Those who want more flexible exposure may like the Invesco Monthly Income Bond fund, which currently has half of its exposure to high yield bonds. Another is the M&G Optimal Income fund, managed by Richard Woolnough, which has around 20% in the high yield space.
Darius McDermott is managing director FundCalibre
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