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US high yield bonds appear to be benefitting from a “Goldilocks” scenario, according to Christopher Mahon, who has allocated close to one-quarter of his Baring Multi Asset Fund to the asset class.
Interest rates around the world are at record lows and the era of ultra-low rates appears set to continue for some time to come. The Bank of England recently moved its base rate down to 0.25 per cent and both the European Central Bank and the Bank of Japan have theirs at zero.
The Federal Reserve is the only major bank considering lifting rates, but at the same time is at pains to reassure the markets that any hikes will be incremental and dependent on economic data remaining robust.
Against this backdrop, investors are seemingly desperate for income as the yield on government bonds and defensive equities move ever lower.
But one area that stands out, Mahon says, is US high yield bonds. Here, investors can still find yields in excess of 6 per cent – which can look attractive when compared with 10-year gilts yielding around 0.7 per cent and the FTSE All Share yielding 3.52 per cent (according to its factsheet to the end of July).
An added bonus is that US high yield bonds are trading at relatively attractive valuations. While the asset class had been more expensive at the start of 2014, the plunge in the oil price prompted a sell-off in 2015 that brought it back down to valuations that were attractive as they were five years ago.
Performance of Barclays US Corporate High Yield index in 2014 and 2015
Source: FE Analytics. Total return in dollar terms between 1 Jan 2014 and 31 Dec 2015. Past performance is not a guide to future returns.
“It is hard to find assets that are just as attractive as they were five years ago, but US high yield is one such example,” Mahon said.
“High yield in early 2014 became very over-bought and this prompted us to sell our entire holding of high yield at that time. We went down to a zero holding simply because it became too expensive. What happened then in 2015 was the US shale oil story, which was backed heavily by the high yield market. High yield sold off aggressively - both shale parts and non-shale parts - when the oil price fell. The market was unable to distinguish between the two.”
“What you were left with at the beginning of 2016 was a market looking very cheap indeed. We started building up a substantial position in the fund across the early part of 2016 and it's now over 20 per cent of the portfolio.”
“What I think is very important to do is to distinguish the parts of the market that are shale-related from the parts that aren't shale-related. Both have been sold off, this is why there is this opportunity,” he said.
“We're looking for positioning that doesn't have too much shale exposure.”
Underpinning Mahon’s view on the US high yield sector is the belief that it is currently in somewhat of a “Goldilocks zone”, where the economy is neither to hot nor too cold. The US economy is strong enough to keep a lid on defaults – which are a risk for high yield bonds – but not so strong as to encourage e the Federal Reserve to start aggressively lifting interest rates.
“Our view on the US that it’s one of the more reliable growth markets in the world. It may not be anything exciting like 3 or 4 per cent growth, where people want it to be, but it's reliably around the 2 per cent mark,” the manager said.
“For us this is really Goldilocks conditions because 2 to 2.5 per cent is ample room against defaults being generated. It is also not so fast that it creates conditions for the Fed to change its tone, so we think this type of market is one of the more attractive around given the conditions of growth not being at exciting levels but not being in a recession either.”
“High yield is very attractive on a risk/reward basis, that's why we have 22 per cent of the fund invested in US high yield. We believe when you look at other markets such as the equity market, which is incredibly sensitive to macroeconomic events like the Italian referendum, one of the better alternative risk/return opportunities is in US high yield bonds and we've been happy to make this a very meaningful part of our portfolio.”
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