FE Analytics shows the BofA ML Sterling High Yield index dropped 1.38 per cent over the course of September.
Over the longer term high yield bonds have climbed rapidly - the index is up 109.20 per cent over five years - leading some to become concerned that the asset class is now overvalued.
Eoin Walsh, who runs the £566.7m PFS TwentyFour Dynamic Bond fund with Gary Kirk, Felipe Villarroel and Pierre Beniguel, notes that September was the worst month of 2014 for high yield.
“On the face of it, this might not come as a big surprise, the credit markets had rallied a long way, with high yield being one of the best performing sectors and industry commentators highlighting how expensive the sector had become since early this year. Therefore it seems only sensible that high yield is now suffering from the summer-long sell-off in credit.”
Spreads in the high-yield market tightened in early 2014, moving to 483 basis points, and led the PFS TwentyFour Dynamic Bond fund to reduce its exposure to these bonds.
However, it has widened significantly since and now sits just below 600 basis points.
Performance of index and sector in Sep 2014
Source: FE Analytics
Walsh said: “Given the widening in the sector the question now becomes – is it too cheap? Given the strength of selling in high yield and the outflows seen from ETFs you could conclude that there is further to go in high yield, but as stock pickers, we are certainly beginning to see strong names that look to be oversold.”
According to the manager, the ultimate determinant of whether a high yield investor was paid enough to take risk over the medium to long term is the level of defaults and these are currently close to all-time lows.
Furthermore, he says it is “difficult” to see defaults spiking higher over the short term.
“While investors certainly need to remain cautious and it is true that some very small and highly levered companies have issued high yield bonds and ultimately the refinancing of this cheap debt could prove problematic, you can probably no longer argue that high yield is simply ‘expensive’,” Walsh said.
“While the sector might still get cheaper, it should be beginning to look attractive to investors again.”
Sentiment towards high yield bonds has weakened after the market started to price in the prospect of interest rate rises from the like of the Federal Reserve and the Bank of England.
However, some commentators believe that high yield could hold up well in this environment if central bankers stand by their pledges that rate rises will be gradual and incremental.
Willem Sels, UK head of investment strategy at HSBC Private Bank, says further damage to the bond market is likely to be limited even if volatility increases after a relatively flat year, as a number of rate hikes are already priced in.
“If yields indeed only rise gradually, investors should continue to show interest in credit, especially as credit fundamentals remain strong,” he added.
“Where portfolios can take a buy and hold approach to see through some of the volatility, we think exposure to short to medium-dated investment grade, high yield and hard currency emerging market debt makes sense."
Only one high yield bond fund appears on the FE Research Select 100 list of recommended funds - Philip Milburn and Claire McGuckin’s £1.6bn Kames High Yield Bond fund.
The FE Research team said: “The fund’s preference for companies with a low cost-base and that are able to ride out turbulent economic conditions is unlikely to change, meaning it should maintain its defensive characteristics.”
The fund’s bias towards defensive companies means it can lag its peers at times, such as in early 2013 when it fell behind in the market rally.
It was also behind its peers in the run-up to the credit crunch but outperformed significantly in the three years after 2008.
FE Analytics shows the fund is first quartile over five years with a return of 55.36 per cent but is second quartile over one year and fourth quartile over three.
Over the seven years of the last market cycle, the fund outperformed its peer group average by almost 10 percentage points.
Performance of fund vs sector over 7yrs
Source: FE Analytics
Kames High Yield Bond has a yield of 4.3 per cent and a clean ongoing charges figure (OCF) of 0.79 per cent.
Independent investment research consultancy Square Mile has the Kames fund in its Academy of Funds, where it holds a AA rating.
Square Mile has three more IMA Sterling High Yield members in its list of preferred funds, all of which have an A rating - Baillie Gifford High Yield Bond, Baring High Yield Bond and Threadneedle High Yield Bond.
Donald Phillips and Robert Baltzer’s £539.7m Baillie Gifford High Yield Bond and Ece Ugurtas’ £730.5m Baring High Yield Bond funds have both outperformed their peer group over three, five and seven years from a total return perspective.
The £789.1m Threadneedle High Yield Bond fund, which is managed by Barrie Whitman and David Backhouse, has slightly underperformed the sector over all three time frames.
However, it has paid out more income than the other funds, which could make it an attractive option for those prioritising income.
Despite the recent sell-off in high yield, not all investors are convinced they are at attractive levels. John Stopford, portfolio manager on the £96.6m Investec Diversified Income fund, is bearish towards corporate bonds, including high-yield bonds.
He argues that equities are presently more attractive than high-yield bonds - even for investors seeking income.
Stopford points out high yield bonds tend to fare less well in times of higher market volatility, as concern about future company prospects mean corporate bonds have to pay higher additional yield to compensate investors for taking risk.
The manager, who is co-head of multi-asset at Investec Asset Management, says “the trough in corporate bond yields may already be in sight” as the business cycle moves on, while the expected shift in central bank policy will push up yields. High yield could also be hit hard if volatility spikes “as investors rush to exit what is a very crowded trade”.
Stopford concludes: “Whilst a rise in volatility may also cause a setback in stocks, the transition to higher volatility didn’t derail the equity bull market in the late 80s, late 90s or mid-2000s, and we don’t see why it should this time either."
“It is too early to call the cyclical top in the equity market, but corporate and high yield bond prices may already be on the way down.”
