High yield bonds, which are sometime called ‘junk bonds’, have always been seen as a riskier part of the fixed income world due to an increased chance that their issuers will default.
However, as the market anticipates the first interest rate rises from the likes of the Federal Reserve and the Bank of England, the asset class is being seen by some as a safer place to be than traditionally defensive fixed income assets such as government bonds.
In fact, following the most recent bond sell-off, the IA Sterling High Yield sector was one of only two bond sectors not to nosedive and the average fund in this peer group has made positive returns since the start of the year.
Performance of sectors in 2015
Source: FE Analytics
One reason why these bonds haven’t been hit as hard in the sell-off is their higher yields offer a greater degree of ‘cushioning’ from rising rates that government bonds, where yields remain very low on a historic basis.
Another good example of the protection high yields bonds offered is the taper tantrum in May 2013, when then-Federal Reserve chair Ben Bernanke announced that he was considering slowing down quantitative easing in the US.
Despite making a loss of 0.39 per cent during May 2013, the high yield sector outperformed all other bonds sectors in the Investment Association universe.
Performance of sectors in May 2013
Source: FE Analytics
In light of the current situation in the debt market, JP Morgan’s Nick Gartside (pictured) has increased his exposure to high yield bonds. 
“Recently, the broader movement in government yields has shaken up some corporate bonds and we have sharpened our pencils to add some attractively valued corporate paper in the investment grade and high yield space,” he said.
“In the high yield debt space, we think European high yield corporates are in good health and show that cash balances for European companies have grown at the fastest rate since 2009 this year, as management teams remain conservative. We are encouraged that European lending conditions are the most positive since 2007, as high yield typically performs well in this environment.”
“There is a risk that volatility in rates markets has a knock-on effect in the real economy but we point out that the spread between government bonds and lending rates in the real economy looks large by historical standards. We remain constructive on European and US high yield.”
In terms of the US, Gartside says that the increase in M&A volumes and share buybacks as well as high levels of new issuance has put pressure on spread levels, causing underlying yield curves to steepen.
Therefore, he believes that credit curves will flatten, creating the perfect opportunity to invest in longer-dated high yield corporates.
Gareth Isaac, fixed income manager at Schroders, is also positive on some areas of the high yield corporate bond market, as well as some investment grade areas. However, he warns that investors need to be selective.
“We have seen a significant amount of new issuance over recent months and quarters. However, credit has performed very well during the government bond sell-off,” he said.
“If our assumption that the rise in government bond yields will slow is correct, corporate bonds can continue to do well. We see US dollar-denominated and sterling corporate bonds as offering more value in this environment relative to euro equivalents.”
Despite believing that volatility in the bond market will ease back as markets move towards realistic valuations for government bonds, Isaac believes that bond investors aren’t going to be in for a smoother ride over the long term.
“Many popular or crowded trades have been washed out by the volatility and the market positioning is a lot cleaner,” he explained.
“As long as interest rates remain at or near zero, cash is not a viable option for investors. Once volatility has abated, investors should begin to step back into the market.”
“Over the longer term, periods of volatility are likely to become more common. The recent turmoil is a sharp reminder of how illiquid the bond markets can be in times of stress. What we have seen may be a small indication of what we can expect if and when interest rates do begin to rise.”
When looking for good high-yield fund options to hold over the longer term, investors might want to consider five FE crown-rated top-quartile funds such as Aviva Investors High Yield Bond, Aberdeen High Yield Bond and Invesco Perpetual High Yield, which have all outperformed their sector average in the IA Sterling High Yield sector over three years and yield more than 4 per cent.
Performance of funds vs sector over 3yrs
Source: FE Analytics
However, analysts at Bank of America Merrill Lynch recently warned investors not to become too complacent about high yield bonds, pointing out that the asset class could still end up facing significant falls in the event of sustained bond sell-off.
“Not only do too many macro headwinds exist to create a compelling story for high yield, but fundamentals are the weakest they have been since the recession – likely creating an environment where looking for a reason to sell becomes easy. We caution investors to not grow complacent,” the bank said in a note last week.
“The risk is for the Fed to surprise markets with a move in September that causes a significant sell-off – particularly within a backdrop of growing geo-political uncertainty. The clock is ticking, in our view, until high yield has a correction of several points and we continue to believe the longer term prospects for the asset class are worrying.”
Pictet Asset Management’s Luca Paolini believes that, as market rate expectations become more volatile, government bonds could become a “rich hunting ground” for investors.
As such, Pictet is currently overweight long-dated Italian and Spanish government bonds and has reduced its exposure to high-yield bonds.
“With European speculative-grade fixed income securities having returned about 3 percentage points more than government debt so far in 2015, we believe it makes sense to scale back our exposure to high-yield bonds to neutral. We have also upgraded sovereign debt to neutral from underweight,” he explained.
“Although high yield bonds should draw support from the eurozone’s economic recovery and the ECB’s heavy dose of monetary stimulus, the asset class’s yield spread looks increasingly unattractive compared to that offered by either Italian or Spanish sovereign debt.”
The sell-off in government bonds last month caused the yield gap between Italian and German sovereign debt to widen by around 50 basis points. Spanish bond markets were also impacted similarly, and Paolini believes that these gaps are erroneously high.
Whether investors prefer government bonds, investment grade corporates or high yield bonds, BlackRock’s Scott Thiel believes that maintaining as much diversification as possible is the simplest and most effective way to protect against any headwinds facing bonds.
“The recent spikes in bond market volatility highlight that there are two really key factors at play in fixed income, neither of which are likely to change any time soon and that mean volatility is here to stay in the near-term: firstly, central bankers are the major players in markets and investors hang off their every word. Secondly, Illiquidity in bond markets exacerbates bouts of volatility,” he said.
“So what precautions can investors take to brace themselves? Well, it’s important to remember that active managers view volatility as a good thing – it creates opportunity. However, whether an active manager’s objective is to beat a benchmark or they are more unconstrained in their strategy, I believe today’s market conditions mean it’s critical that they are flexible, by which I mean they are empowered to use derivatives, for instance, and can utilise the widest possible opportunity set to build a portfolio that protects against sudden market moves before they happen.”