There could be a buying opportunities showing in the high yield bond market given current valuations, according to Kames Capital’s Thomas Hanson.
Hanson, head of high yield at Kames, said: “Given where spreads and yields are, and given the central bank support, especially the Fed, it feels as if you are being compensated for risks a lot more than you were long time ago.”
The manager, who runs the £432m Kames High Yield Bond fund with Mark Benbow, is seeing a “meaningful shift” in sentiment in the market: “We’ve seen fund flows come back, we’ve seen primary re-open and sentiment towards the asset class be improved”.
There was a fear that the number of investment grade BBB issuers had built up and would overwhelm the high yield market if widespread downgrades were seen. However, Hanson noted that the economy had been in a late-cycle stage for a long time and said that “fallen angels were a risk before the coronavirus even kicked off”.
So when the Federal Reserve stepped in to buy corporate bonds, including high yield ETFs, Hanson said: “What the Fed did really is underwrite some of that risk, taking some of that risk away”.
Performance of bond sectors in 2020
Source: FE Analytics
Hanson revealed that there were some difficulties with liquidity during the bond market rebound as well as during the sell-off.
“When the market was selling off, bids were hard to come by. But actually what you saw on the way back up, offers were hard to come by as well when you wanted to buy bonds,” the manager said.
He explained that offers were not being seen in the higher-quality part of the market, which is what the majority of investors wanted to buy at the time.
“When we saw the market bounce, everyone saw the opportunity in BBs, everyone was after the bonds that had sold off in the higher quality space, because when the sell-off happened it was absolutely indiscriminate,” Hanson said.
“What we noticed was that lower-rated cyclicals had lagged, so on a spread basis there has been and continues to be more opportunities in the lower rated space.”
During March, the main focus of Kames High Yield Bond was preserving liquidity, with the portfolio having a slightly higher cash balance than normally would have done. This higher cash allocation is still in place.
Hanson said that how the fund has tried to find value is by buying up some of the beaten-up higher-quality names, as well as “going over our credit research, being patient, and making sure we’re comfortable with the stories that we own”.
The primary market has some great opportunities, he added, “as these companies attractively price new issues to try and get their deals done in the market, and done well”.
Hanson highlighted the fund’s participation in the Carnival Cruises bond issue, which pays a 11.5 per cent coupon secured.
“The reality is that the underlying business is going to struggle, but we had enough security through our position in the capital structure to be able to buy those bonds with confidence, and clearly we’re attractively compensated for doing so,” he added.
While the fund still holds a lot of BB and B rated bonds, it is currently overweight CCC as it is often easier to find good alpha generating stories in the lower rated part of the high yield market, argued Hanson.
“The lower rated names tend to be where investors find more alpha opportunities, because they are often smaller and more under researched,” he said.
“In European high yield, where BB forms 70 per cent of the investment universe, you are going to have to be significantly involved in that part of the market one way or another.
“We often find there is a lot of opportunity in the smaller sized lower rated names because a lot of the big payers can’t get involved in them”.
“If you have a very large amount of assets under management, it's quite hard to gain critical mass in a bond issue that is only £250m in size, because the reality is if you wanted 1 or 2 per cent in it, you’re essentially going to take up all that liquidity in that issue.”
But Hanson warned that as an investor gets further down the rating scale, it is risky to talk about broad rating cohorts.
He emphasized the importance of distinguishing between different underlying companies and said that understanding individual situations was “key to unlocking value in the market”.
He highlighted the recent €200m bond issue by Swedish home security company Verisure as a good example of how there is still demand for high yield at the moment, particularly in Europe.
“Verisure have some sub bonds out there rated CCC, they're 7x levered, which is why they’re rated CCC, but the reality is it's quite a stable business with stable earnings dependable cash flows, so it's all about understanding the story, that's how you add value.”
Hanson, whose fund holds a 2.1 per cent position in Verisure bonds, said the deal “went really well” and was 8.5 times oversubscribed.
“A lot of these companies are good businesses. They may carry more leverage that pushes them down into the high yield part of the market, but they have good business models and good management,” Hanson explained.
Giving his thoughts as to whether buying up bonds in the high yield market was a moral hazard on the Fed part, he said: “I think bailing out the banks in 2008, which absolutely had to be done, is potentially more open to challenges of moral hazard then trying to support companies that are in the real economy, that are providing jobs to people and ultimately are going to be part of that economic productivity that you're going to need on the other side when you get out of this.”
During shock like Covid-19 that renders businesses obsolete overnight, he said it is unfair to single a group of companies as not being worthy of support when broad based support is being offered elsewhere.
Performance of fund vs sector over 5yrs
Source: FE Analytics
The Kames High Yield Bond fund has generated a total return of 2.24 per cent over the past five years, compared to 8.22 per cent from its average IA Sterling High Yield peer.
The fund currently yields 6.01 per cent and has an ongoing charges figure (OCF) of 0.60 per cent.