UK equity markets are at risk from a sell-off because of a further spike in yields in the high yield bond market, according to Georgina Hamilton (pictured), co-manager of the CF Miton UK Opportunities fund, who thinks contagion could cause another dose of bearishness in stocks. 
It has been a wild ride for investors in the high yield bond market with a number of corrections occurring in the past year due to falling energy prices and fears of a global recession.
Performance of sector and index over 1yr
Source: FE Analytics
This has been somewhat mitigated by the extension of quantitative easing [QE] by European Central Bank president Mario Draghi’s recently, with many investors tempted back into market.
However, for Hamilton there is a worrying risk of contagion into equity markets from the high yield bond market should investors become jittery once again. This risk she thinks is currently overshadowed by the Brexit referendum but just as pertinent.
“There is a major risk out there that it is worrying us. The high yield market, also known as the junk bond market, especially that of or related to the energy sector. This worries us because if anything is related to having too much debt it can spread and have knock on effects and we need to be aware of those,” she said.
High yield bonds are seen by many to be most at risk in the energy space as a result of the low oil price, and by extension broader energy prices, with some investors fretting it will raise the rate of defaults.
“These high yield bonds are not held too much by the banks, they hold some but they are mostly held by a variety of pension funds insurance funds or mutual funds. This could cause a problem because those invested could have different time horizon than the underlying product and that can cause a problem,” Hamilton added.
“As it stands at the moment things appear to have improvement in the high yield market and panic appears to have dissipated. But given the extent of the problem we think it is wise to keep a focus on it.”
AXA IM’s Chris Iggo thinks the default rate in high yield will increase over the next year or so but that this will be contained in the oil and gas space and not spread to other areas.
“We do expect high yield defaults to rise over the next year or so, but the bulk of the increase in defaults will come in oil and gas, and related sectors where cash flow has been severely impacted by the decline in oil prices,” Iggo said.
“Away from this sector, however, spreads are suggesting a default rate that looks too high.”
At the same time as being concerned about high yield bond space into the equity market (where CF Miton UK Opportunities operates), Hamilton and co-manager George Godber are also avoiding the shares in the oil majors such as BP and Shell.
“We are still struggling with the major oil shares, we are really struggling to find any ideas in that major oil space. We think they are paying their dividend out of debt for the foreseeable future and that is an unsustainable situation to be in,” Hamilton said.
“They have an enormous amount of leg work to do to get back to solid enough balance sheets for us to finds them investable.”
Hamilton also told FE Trustnet that she and co-manager George Godber do see Brexit as a threat to markets but less so than a collapse in the high yield market.
“Running a UK fund, Brexit is an important thing to consider and there’s two factors to it, one is people positioning ahead of Brexit to try to mitigate any risk and how people are positioning in advance.”
“Given that the probability remains that we will continue within the EU, as it stands we will not change our positioning on the basis that we expect we might come out but we are definitely aware of where the risks might be within the fund and have identified those in advance of the event.”
“Given that the probability remains that we will continue within the EU, as it stands we will not change our positioning on the basis that we expect we might come out but we are definitely aware of where the risks might be within the fund and have identified those in advance of the event.”
Co-managed by Hamilton and Godber since launch three years ago, the CF Miton UK Value Opportunities fund has made a 57.83 per cent total return over this period, which ranks it top in the IA UK All Companies sector compared to a peer average return of 17.40 per cent and a gain in the FTSE All Share index of 11.94 per cent.
Performance of fund vs sector and index since launch
Source: FE Analytics
Richard Woolnough, who heads up the £14.95bn M&G Optimal Income fund, is also not so worried by the EU referendum, and in fact thinks high yield bonds are attractive and not due another selloff.
“The market is incorrectly pricing future default rates. In the UK for instance, the level of BBB bond spreads implies around a 4 per cent annual default rate, which is way in excess of the historical average of around 0.4 per cent,” Woolnough said.
“So the market has become overly pessimistic and we are therefore happy to take credit risk in the fund, given the high level of compensation on offer. This also extends to high yield, which now makes up around 33 per cent of the fund from 25 per cent last year, representing a ‘neutral’ positioning, from an underweight previously.”
Vincent Juvyns, global market strategist at JP Morgan Asset Management, also thinks high yield – particularly in the European space – is attractive.
“We have an underweight exposure to most areas of fixed income. However, the high segment of fixed income is becoming interesting after a period of sustained weakness and we think valuations are beginning to price in higher levels of defaults than we expect. The sector also offers a decent yield at a time when income can be hard to find without putting capital at risk.”
Marcus Brookes, head of multi-manager at Schroders, has also recently sought out further exposure to high yield bonds but chooses to access the space through the £3.4bn JPM Income Opportunities fund, managed by Bill Eigen. He says Eigen can scoop them up in the short-lived period that they remain cheap.
“He [Eigen] has been steadily increasing exposure to the high yield sector and it now accounts for almost 50 per cent of his portfolio, the maximum allowed by his mandate. He is an opportunistic manager and will sell down his exposure again when he thinks the opportunity has passed,” Brookes said.
CF Miton UK Value Opportunities has a clean ongoing charges figure (OCF) of 0.83 per cent.