High valuations, a diminishing quality of issuance and falling liquidity are all reasons why investors should sell out of high yield bonds, according to Tim Beck, manager of the Stenham Credit Opportunities fund.
Thanks to an extended period of ultra-low interest rates and quantitative easing from the world’s central banks, high yielding bond funds have delivered phenomenal returns to investors over the past few years, with very little downside.
According to FE Analytics, the average fund in the IA High Yield sector has returned a hefty 113.52 per cent since the market bottomed out after the 2008 financial crisis. While this figure is lower than the FTSE All Share’s gains over that period, it has been achieved with far less volatility.
Performance of sectors versus index since March 2009
Source: FE Analytics
Those returns have come at a cost, however, as the average fund in the high yield sector now yields a relatively low 5.22 per cent.
Nevertheless, given that the sector has gone through a period of heightened volatility and dull performance thanks to the fall in commodity prices and fears of an interest rate hike in the US, a number of experts have labelled the asset class as attractive given that inflation is very low and defaults have been virtually non-existent.
On top of that, given that high yield has historically been less sensitive to interest rate movements, some analysts expect the sector to continue to perform well over the medium term.
However, Beck says that investors should expect a very rocky period from their high yield bond fund over the coming years.
“A lot of credit is trading close to all-time tight yields and all-time high prices, but the quality of issuance is deteriorating and the structure of the market is inherently less stable than in the past,” Beck said.
“The zero interest rate policy adopted by the developed world’s central banks has driven down yields to historic low levels. At the same time, regulation has restricted the ability of banks to take risk, with the (unintended) consequence of a lack of liquidity in the market.”
“Retail investors, who may be more flighty at times of stress, have also become more prevalent in the market.”
“If we experienced any shock, be it credit or interest rate related, there is no marginal buyer until yields are substantially higher and prices concomitantly lower. So for traditional investors in credit, the potential returns are constrained and risks elevated.”
With that in mind, Beck drills down further to highlight the five major reasons why investors should look to switch out of the high yield bond sector.
Yields are at all-time tights and prices above par
Firstly, the manager says that valuations are worryingly high.
While yields within the sector may look attractive at more than 5 per cent – especially compared with the paltry yields on offer from government bonds such as gilts, treasuries and bunds – Beck warns low quality bonds are now much more sensitive to interest rate movements than they have been in the past.
Another concern, according to Beck, is that many high yield bonds are now trading at or above their call price, which means investors could be hit by capital losses.
“These bonds are often call-constrained, in that issuers have the right to buy back these securities at a price above par at some point in the future,” Beck said.
He added: “This constrains how high prices can rise in high yield, whereas investment grade bonds for example can regularly trade well above par. We believe returns will be limited to the current yield at best.”
Hermes’ Fraser Lundie warned FE Trustnet about this systemic risk within the high yield market in an article last year.
Spreads not compensating for default risk
One of the major reasons why many investors have felt comfortable buying high yield bonds over recent years is because default rates – which have historically been the major risk within the sector – have been extremely low.
The reason for this has been because, due to the ultra-low interest rate environment, companies have been able to refinance their debt at a very low cost. Given that most companies have already come to the market, bulls say there is no reason why defaults should meaningfully increase over the coming years.
However, Beck says that as yields have fallen considerably recently, investors simply aren’t being paid for holding debt issued by companies with low credit ratings anymore.
“Defaults are low and may well remain so for the next couple of years,” he said.
“But spreads, particularly at lower rating levels, are not compensating for average five-year default rates. Defaults may well remain low for an extended period, but given the uncertainties over the global economy, we do not believe this is a good enough reason to own the asset class.”
Credit quality deteriorating
On top of that, the manager warns that the quality of debt issued by companies with lower credit ratings is also falling.
A number of experts have warned about this phenomenon as, given there is such demand for higher income-paying assets, issuers are increasingly able to make the terms of their covenants far more favourable for themselves, to the detriment of the bond buyer.
Beck agrees and says this is a major problem.
“With the high demand for credit, quality has deteriorated and issuers have been able to dictate terms. Covenant-lite loans, which attracted such bad press in 2008/09, are now significantly higher as a proportion of issuance and the absolute volume is a multiple of that seen pre-crisis,” he said.
Falling liquidity
A note published by RBS last year revealed that liquidity in global credit markets, which it defines as a combination of market depth, trading volumes and transaction costs, has declined by around 70 per cent since the financial crisis, and is still falling.
While this poses a problem for all fixed income managers, Beck says this development represents a major issue for long-only managers in the high yield space.
“The high yield market has grown significantly since 2008, with the zero interest rate policy driving demand. However, regulation has at the same time limited the ability of banks to hold risk and inventory,” Beck said.
“Historically, banks have taken both a principal and agent role in credit markets – helping them function by providing an incremental bid for assets at times of stress. Since the financial crisis, the capacity to hold risk has been much reduced and the role is much more limited to that of an agent.”
He added: “It is unclear who would be the marginal buyer of credit. This could create a gap in pricing, with the potential for strong asymmetric returns from shorting.”
Less stable investor base
The final worry, according to the manager, is a concern due to the four other reasons mentioned so far.
Beck says that while high valuations, falling liquidity, lower quality of issuance and a lack of compensation against default are all risks in themselves, the fact that the asset class is home to an increasing number of retail investors – who are in search of higher levels of income – seriously compounds things.
“The holders of credit have changed since 2008, with retail investors increasing the proportion they own through both mutual funds and ETFs.”
Beck added: “Longer-term investors (insurance companies and pension funds) have declined steadily. Retail investors may be more likely to sell at times of stress, which would cause greater price declines.