Fixed income has been the historical home of the cautious investor and not only have bonds protected capital well in the past, the vast majority of bond holders have seen substantial capital gains over recent years.
Performance of sectors over 15yrs
Source: FE Analytics
However, as the developed world continues to recover from the depths of the financial crisis and with central bank monetary policy expected to loosen over the coming years, the outlook for fixed income looks increasingly challenging.
Clearly, investors still need protection in their portfolios, especially given that the outlook for equities also looks turbulent. With that in mind, we ask the experts what are the major risks are for investors who want to buy a bond fund now.
Prices are expected to fall
The majority of experts believe that over the coming years, the prices of gilts are expected to fall – causing yields to rise – as the economy recovers. Though it doesn’t appear to be an immediate risk, future rate rises and the threat of inflation would also have a detrimental impact on bond yields.
This will have far reaching consequences for credit markets – both investment grade and high yield – as they are priced off gilts and treasuries and are also viewed as being quite expensive.
Ten-year gilts currently yield 2.65 per cent and while they had been north of 3 per cent at the start of the year, they were below 2 per cent at the start of the year.
While the majority of experts don’t expect yields to move upwards in a straight line, they say investors should expect them to trend higher over time.
Performance of sectors vs index over 1yr
Source: FE Analytics
However, as the graph above shows, some areas of the fixed income market have still performed well; especially high yield, therefore lower quality, credit.
Phil Milburn, manager of the £1.7bn Kames High Yield Bond fund, says that although investors have been hunting for income and have been more comfortable taking risk, the outlook for his asset class looks difficult from here on out.
“Valuations, to be honest, are stretched,” Milburn said.
Covenants are becoming increasingly poor
Normally, the major risk facing investors in high yield bonds is the increased likelihood of default.
While Milburn says the outlook for lower quality credit is more challenging than it has been, he says that companies haven’t been massively levering up their balance sheets.
FE Alpha Manager Ian Spreadbury recently told FE Trustnet that, as interest rates have been low and are expected to stay around their current level for some time to come, the chances of default rates spiking over the next two years is low because companies have been able to refinance themselves at very cheaply.
He does warn, however, that when rates do start to rise a number of “zombie firms” will cease to exist.
Milburn isn’t too concerned about defaults yet, but he says that as the demand for high yield is so great, issuers are managing to loosen covenants which means that investors aren’t as well protected as they have been in the past.
The covenants are the commitments made by the issuer of the bond to, for example, not raise debt at better rates or not allow the overall debt burden to get too high.
“In high yield, the area where we are seeing the most ill-discipline is not on the balance sheet, but in the structure of the new deals coming to the market,” Milburn said.
“If you look at the traditional high yield bond structure, you have quite a few protections, certainly relative to investment grade, and you need those protections to stop companies going off and doing bad things.”
Call dates are becoming much shorter-dated
Another risk, again specific to high yield, surrounds when those bonds can be called; which means the company pays back the bond earlier than its maturity date and the holder loses future interest payments.
“Especially in European high yield, a lot of the risk is becoming asymmetric. In particular, the call risk embedded within the bonds,” Milburn explained.
“Normally, when you issue a high yield bond, the issuer is at one of its riskiest stages. They are either doing a share buy-back or are refinancing the whole capital structure and we the investor tend to get paid a bit of a premium for committing our resources; we want to own the debt of that company with a higher coupon as possible.”
“However, we don’t want to give the company too long, so our favourite structure is a six, seven or eight year traditional bond.”
“The high yield company wants to pay back that money as soon as possible because they see it as expensive debt, relative to bank debt or investment grade debt, and will therefore want to call that debt as soon as possible.”
Milburn says that, on average, if a bond has an eight year maturity then a company can call back the bond after four years if it is trading at, or above, a pre-determined price.
As Hermes’ Fraser Lundie recently told FE Trustnet, the problem facing the market is that call dates are becoming shorter – due to looser covenants – but at the same time the demand for high yield is going up and up.
Therefore, some people are buying bonds that are trading at, or above, their call price because they want more income. While those can’t be called yet, when they can people who hold the bonds will be hit by capital losses.
Milburn added: “To put it simply, things are now starting to swing more and more in favour of the issuer. It’s not the end of the world yet, but it is something you need to be very aware of.”
Returns will be much lower than they have been
Given those more niche risks and given where valuations are, Milburn expects returns from his asset class to be far lower than they have been over recent years.
According to FE Analytics, Milburn’s Kames High Yield Bond fund has been the fourth best performing portfolio in the IMA Sterling High Yield sector over five years with returns of 100.62 per cent.
Performance of fund vs sector over 5yrs
Source: FE Analytics
On average, his fund has returned 19 per cent in each of the last five discrete calendar years. He says that, from here, the most realistic annual returns over the next two to three years will be mid-single digits.
He also warns that we are coming closer and closer to a period of weak performance from high yield.
“The big test for me and my team over the next three years will be how we perform at the end of the cycle.”
“High yield tends to have a small sell-off on the first US rate-rise. After that, it tends to do OK again as the economy is still recovering.”
“However, by the fourth or fifth rise, by which point the Fed is slowing the economy, high yield at five and a bit doesn’t look too attractive.”
“What we need to do is make hay while the sun shines and try and make single digit returns over the next few years. In two or three years, we need to make sure we are ready for the beginnings of a downturn,” Milburn added.
