“Things are never ‘good’ or ‘bad’ within high yield. Rather, the segment’s very diverse range of sectors are all going through different cycles.” 
Artemis Global High Yield strategy manager David Ennett really does sum up some of the uncertainty surrounding the sector at present. Yes, there are opportunities, but the dangers are stark with the pandemic making sure that cutting through the noise is no easy task.
During the sell-off in March, JP Morgan’s Default Monitor was projecting default rates for 2020 above 10 per cent for the sector. This was when concerns over the economic impact of Covid-19 were heightened and prior to the announcement of fiscal and monetary support by governments and central banks.
But by the start of October, forecast default rates for US high-yield bonds were down to 6.5 per cent for 2020 and 3.5 per cent for 2021. From a regional perspective, I was recently told that Europe’s stood at 4.3 per cent for 2020.
And high yield bonds are in the spotlight right now, as investors look for an alternative source of income at a time when a large number of UK companies can’t pay dividends, and both cash and government bonds are near zero. The idea of 5-6 per cent yields has intrigued numerous investors, despite those risks: figures from the Investment Association show the Sterling High Yield Bond sector has seen £700m of inflows between April and August 2020.
Opportunities and risks – fallen angels and zombies
The impact of the pandemic has seen a rise in ‘fallen angels’ – which have been downgraded from investment grade to sub-investment grade. There have been some 41 fallen angels in the first nine months of 2020 – 19 of which have been in the US. Names like Ford, Kraft Heinz and Marks & Spencer all make the list globally and a recent S&P report says the 2020 total is on track to beat the 2009 record of 57.
There are pros and cons to this. Research shows that although the risk of fallen angels defaulting is initially higher than for those already in the high yield space – after a year the size/scale of these companies gives them an increased chance of moving back to investment grade.
A concern would be the degradation of covenants and their impact on the high yield market – amid the surge in demand for high yield bonds and the record issuance from businesses. These covenants typically impose restrictions on the leverage allowed on a balance sheet, as well as an obligation to gain existing bondholder approval before issuing additional debt – as well as paying possible penalties when leverage hits certain ratios.
A research note from Aviva Investors also says the level of demand has given high yield markets across the globe more freedom to loosen restrictions – as well as use loopholes to report leverage that does not support their real cashflows – allowing them to add debts without seeking approval from existing investors.
Aviva Investors senior global high yield portfolio manager Sunita Kara says investment-grade companies do not require covenants and many have continued to issue bonds as high yield firms without investors requiring them to change their practices. The note adds that this could leave investors open to unwanted risk, such as when a debtor company issues new bonds.
It says that: “Without these in place to restrict issuance, the quality of bonds may degrade without investors being adequately compensated for the additional risk, or even consulted as to whether they are willing to take it on. Combined with the difference in fundamentals across sectors and firms, weaker covenants are leaving investors exposed.”
There is also the fear of poor businesses staying afloat on the back of the additional stimulus. Aviva Investors highlights the growth of zombie companies – essentially issuers generating profits lower than the interest payable on their debt for the last three years. These companies must borrow money to pay the interest they owe – simply to stay in business. These challenged businesses could default very quickly should monetary policy no longer remain supportive in the future.
Where is the value?
Figures from Bloomberg for the first nine months of 2020 would indicate that investors have been better placed targeting higher-rated high yield bonds. BB and single-B rated bonds returned 4.2 per cent and -1.1 per cent respectively, while CCC’s have fallen 7 per cent.
Ennett says the team have been sceptical towards CCC-rated credit within high yield – adding that over a full cycle, the risk-adjusted returns of CCC-credit are poor. However, this has changed recently, adding that while its return profile is now similar to the broader high yield market, they have also demonstrated strong returns following the cyclical sell-offs – given their poor performance going into them.
Ennett says it’s also due to “the downgrade cycle pushing many otherwise sound, cyclical BB/B-rated credit names into CCC at the market’s nadir.” He feels many of these companies buffeted by the cyclical slump are positively exposed to conditions as they improve.
Baillie Gifford High Yield Bond fund manager Lucy Isles says she is looking at companies that can thrive in any scenario, but does acknowledge we are in a unique situation where viable businesses are struggling for sales, and taking on more debt to meet the challenges and aftermath of lockdown.
However, Isles says they are focusing on the higher quality end of the market as many are trading down due to the sentimental fear. The team do not want businesses making drastic changes in order to turnaround their fortunes. She says the team are very conscious of fallen angels and have been doing a lot of work in preparation for companies coming to market – adding there are opportunities. She points to cruise ship operator Carnival as an example – saying that they issued debt at the worst time for them and the best time for investors. The firm has subsequently become an addition to the portfolio following the issuing of a short-dated bond with an 11.5 per cent yield.
We have a reasonable weighting in high yield in both our VT Chelsea Managed Balanced Growth and Monthly Income funds. Clearly, the defaults are a concern, but earlier this year we felt the predicted rate was so high it was hard to imagine what was being priced in would actually transpire – that was an opportunity in our eyes.
High yield has since bounced in the region of 20 per cent in the past six to eight months. Clearly, it is not as attractive as it was then, but you can still get 5 per cent yields in an income-starved world, and I still believe it has a place in a portfolio. But you do have to be wary of certain sectors like travel and leisure – where a recovery is likely to be more elongated.
Investors who want direct access to the high yield space may like the Baillie Gifford High Yield Bond fund, managed by Isles and Robert Baltzer. This fund offers investors access to a portfolio of predominantly UK, US and European high yield bonds.
Those looking for flexible exposure may like the Jupiter Strategic Bond or the Invesco Monthly Income Plus fund both of which have reasonable holdings in high yield companies.
Darius McDermott is managing director at Chelsea Financial Services. The views expressed above are his own and should not be taken as investment advice.