With traditional fixed income assets such as corporate and government bonds yielding very little, investors have been forced into more risky areas such as high yield credit to eke out returns and find a decent level of yield.
This hunt for income has meant areas such as European high yield have become popular among strategic bond managers and as a result the asset class has rallied over recent years.
Performance of index over 3yrs
Source: FE Analytics
Data shows that the European high yield credit market is now yielding 4.5 per cent with a spread of 3.75 per cent – the lowest either have ever been and reflecting high prices on bonds.
The spread is the difference in yield received between a corporate bond and a government bond of the same duration, effectively what you get paid for taking greater credit risk.
Rob Jukes, global strategist at Canaccord Genuity, says that investors are now overpaying for high yield across global bond markets, and therefore any interest rate hike could have serious knock-on effects as companies struggle to fund their borrowing.
“I do think there is a real risk here,” he said. “I think it is absolutely right that companies are viable at these levels of über-low interest rates, but there are lots of companies that won’t be when rates start to rise.”
“The names you should be careful of are sectors like utilities and other highly geared companies,” he added.
FE Alpha Manager Ian Spreadbury (pictured), who runs the £1.4bn Fidelity Strategic Bond fund and the Fidelity Global High Yield fund, says that when rates rise, the number of companies that will be unable to service their debt will increase.
“A way of looking at it is that it is keeping poorer quality companies afloat, which is certainly a risk,” Spreadbury added.
“These companies have a combination of leverage, not just financial but also operational as well. The combination of the two is not good if cost inflation pressures come through.” “When there is an interest rate squeeze, then we could see a number of organisations unravel pretty quickly,” he added.
Spreadbury, however, is happy to maintain exposure to high yield within his funds at the moment.
“I always get asked, 'how can you justify buying high yield bonds at that level?' It’s not even high yield anymore. However, with default rates running at just 1 per cent, there could still be value left in European high yield,” the FE Alpha Manager said.
“We are still seeing strong inflows into the market and I expect this to continue. While in the short- to medium-term valuations do look stretched, the reason it will continue to do well is because of very loose monetary policy, which means that companies can refinance themselves at a very cheap rate.”
Spreadbury has managed the Fidelity Strategic Bond fund since April 2005. He holds around a third of the portfolio in global high yield bonds, though his largest individual position is the FF Institutional European High Yield fund. It does, however, make up just 1.9 per cent of his assets.
The fund is yielding 3 per cent.
It is the third best performer in the IMA Sterling Strategic Bond sector since launch, with returns of 67.93 per cent, beating the average fund by more than 20 percentage points.
Performance of fund vs sector since Apr 2005
Source: FE Analytics
However, the fund has struggled to maintain that performance recently, delivering second quartile returns over three years and third quartile returns over one and five.
The best performing strategic bond funds in recent times have tended to be those with a much larger allocation to high yield credit.
For example, FE Analytics data shows the five crown-rated Royal London Sterling Extra High Yield fund – which has 41.95 per cent in BB or lower rated credit and a further 38.6 per cent in unrated bonds – is the best performer in the IMA Sterling Strategic Bond sector over three years, with returns of 41.85 per cent.
Performance of fund vs sector over 3yrs
Source: FE Analytics
The major counter argument against the increasing risk of default in the European high yield market is that the ECB has only just slashed rates to 0.25 per cent.
The majority of experts point out that as the eurozone is further behind the US and the UK in terms of its economic recovery, interest rates are likely to stay low for a long time to come.
Jukes says the other major risk facing high yield investors is that, given the currently high valuations, the asset class is becoming susceptible to movements in the government bond market.
The major reason for this, Jukes says, is because corporate earnings growth is nowhere near the levels needed to justify the current multiples on equities or the narrow spreads on corporate bonds.
“I would normally talk about this in terms of equities, but it is now equally valid for corporate credit,” he said.
“Risk premia has been coming down, which has led to multiples expansion in the equity market and spread contraction in the credit market. This has happened for various reasons; however, without earnings growth it means they both look unattractive.”
“They already look expensive, but if government bond yields were to spike, high yield bonds would be even less attractive. Earnings growth is not only important for equity valuations, but it is also important for credit markets because it helps service debt.”
“There is now a likely chance that we see a valuation correction in both equities and corporate credit as the performance of government bonds could become positively correlated.”
“If you were to see a spike in government bond yields, there could well be an even bigger spike in credit yields because spreads are historically narrow,” he added.
