The combination of rising rates and persistent inflation have turned most of the bond market into a wasteland for investors today.
It’s a challenge facing the entire asset class. Last week we saw inflation break through the 6% barrier (6.2%) – the highest level in three decades. Today, 10-year UK government bonds are yielding around 1.6%, which means you are losing around 4.5% of your purchasing power every year.
Meanwhile, with a spread of 153 basis points above 10-year government bonds, you are also losing around 3% of your purchasing power in sterling investment grade as well.
Although the spread over the risk-free asset has been better in global high yield (it currently stands at 461 basis points) – it’s the one segment of the market offering some value.
Resilience has been the order of the day for high yield bonds – the global high yield market is down close to 6.3% year-to-date in sterling terms, which isn’t bad when you consider Eurostoxx and the Nasdaq are both down 15%.
But perhaps we should not be so surprised. As Man GLG High Yield Opportunities fund manager Mike Scott points out, high yield markets have historically performed relatively well during periods of inflation. Although stagflation would be a far greater concern, with nominal growth running at 8-10%, he feels it is an outside risk.
Figures from Janus Henderson support this view – in six of the past eight environments where US inflation has risen high yield bonds have delivered double digit returns.
This is not to say every high yield company will prosper – pricing power will be essential. High yield as a universe has historically had a high weighting to materials and energy issuers, so higher commodity prices may ultimately help the cash flow of these companies.
Artemis Global High Yield Bond co-manager Jack Holmes cites three specific reasons why high yield offers an attractive source of returns in the current climate.
The first is that high yield has a low duration – effectively, tightening central bank policy should affect high yield to a lesser degree than other segments of the market.
Figures from Bloomberg show the duration on European and US High Yield currently stand at 3.5 and 4.2 years respectively – compared to 5.2 and 8 years for European and US investment grade.
Jack Holmes also points to the attractive yields or current income in the sector. The global high-yield index currently provides a yield of 6.2%.
He contrasts that with the trailing yield on the MSCI World Equity Index (1.8%), 10-year benchmark government bonds (0.2 to 2%) and investment grade corporate bond yields (3%).
The third area is defaults. As we know, the bargain with high yield is taking that extra risk in a bid to get a greater return above the ‘credit spread’.
Holmes feels that with real economic growth looking very strong over the next few years, the potential for high yield bonds not to deliver on their income is low.
There are reasons to support this view - not least that the quality of the high yield bond market has improved with the percentage of BB companies increasingly meaningfully in recent years, while CCC and below has halved since the global financial crisis.
S&P Global Ratings envisages the global speculative grade default rate to be near historical lows in the first half of 2022 for high yield – possibly below 2% – before rising slightly later in the year.
The final point is where we go from here. Liontrust GF High Yield Bond co-manager Donald Phillips says many high yield market commentators have pointed to CCC bonds as a good place to hide from rising interest rate.
He says that with rising commodity prices, the large cohort of commodity sector bonds in the US CCC-rated part of the market are benefitting.
However, with the fixed, limited upside in bonds, particularly when the market has already largely priced in their current good fortune – he says it is not a theme that bond investors should embrace too readily, adding that defaults are often more prevalent in this segment of the market.
It may be BB rated bonds offer the best risk-adjusted returns, not just because of stronger credit fundamentals but also because they remain popular with investment grade investors who are looking for extra yield and rising stars that may well be promoted to investment grade status.
Ultimately, it is flexibility that investors will need to navigate the challenging environment we currently face. You want businesses with strong pricing power, good cash flows and a stable business model. The importance of a good stock picker in this market cannot be understated.
Investors who want direct access to the high yield space may like the Baillie Gifford High Yield Bond fund, managed by Lucy Isles and Robert Baltzer.
This fund offers investors access to a portfolio of predominantly UK, US and European high yield bonds, yielding 4.5%. Scott’s record as a stock picker in the high yield bond market is second to none – his fund currently yields 5.7%.
Those who might not want a full-blooded approach to high yield bonds may prefer a strategic bond fund like TwentyFour Dynamic Bond or Nomura Global Dynamic Bond, both of which have reasonable allocations to high yield in their portfolios.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above are his own and should not be taken as investment advice.