While credit selection should always be front of mind when investing in high yield bonds, it is even more critical during uncertain economic periods such as the one we face now. The dispersion of returns in the asset class has already picked up significantly and is likely to remain high over the coming months. And, as market liquidity becomes more constrained, any disappointment can lead to significant underperformance by individual securities. Yet while trade wars and lower GDP growth globally are likely to increase volatility in cyclical sectors such as shipping, autos and airlines, as long as investors remain disciplined in security selection, there are three main reasons to be bullish. 
When lower is actually better
First, although credit spreads are below their historical average, this has been driven by lower government bond yields rather than crowded credit market trades, and we don’t think the broader credit market is overvalued. In the continued hunt for yield, we think the asset class continues to offer opportunities.
Second, high yield default rates have fallen below historical averages in parallel with lower spreads. This reinforces the attractiveness of current valuations, as the risk and reward trade-off is stable or has even improved, in an otherwise complex investment landscape.
The relationship between default rates and spreads
Source: Moody’s, Barclays as at 30 June 2019
Third, although there are understandable concerns around future default rates given the economic backdrop, these are mitigated by the low interest rate and low inflation environment. This, in our view, should reinforce the trend of structurally lower default rates.
Moody’s global single-B annual default rates
Source: Deutsche Bank, Moody’s as at 31 December 2018
Again, selectivity is crucial, and on a regional basis we see greater opportunities for security selection in European credits versus US names in the near term, given their lower levels of leverage. There continue to be attractive opportunities in subordinated financials and telecoms.
High yield remains a tourist market in the UK
Despite its relative attractiveness versus other fixed income markets, and in contrast to the US and Europe, high yield remains a marginal consideration for UK retail investors. Many retail buyers are ‘tourist’ investors, dipping in and out of high yield.
Sterling High Yield Net Sales by Period and Distribution Channel (£m)
Source: Investment Association, as of 31 August 2019
This may seem surprising given the hunt for yield that has lasted for over a decade, but is likely to be a legacy of post-financial crisis conservatism. UK retail investors were wary of anything but the safest investments as they adjusted to the new world of “lower for longer”. This tendency was understandable initially, but seems less justifiable more recently, in particular over the last couple of years when other “risky” assets such as equities had the wind in their sails.
Many UK retail investors will have exposure to the asset class within broader bond funds that allocate to both high yield and investment-grade issuers, and those wouldn’t be identified in high yield-only flows. It is also the case that the UK issuer market remains small, possibly discouraging those with a domestic bias (ironically, this could in turn discourage potential issuers, creating a negative feedback loop). And UK retail investors may be more prone to concerns around default rates, particularly with the current uncertainty around Brexit.
From tourist to resident
Nevertheless, given higher yields than many other bond segments and structurally lower default rates alongside careful balance sheet management, more UK investors may soon wake up to the attractiveness of carefully selected high yield securities. Valuations across asset classes look rich, and high yield is a good candidate for taking on risk exposure that can contribute to higher returns while offering portfolio diversification.
Chis Higham is manager on the Aviva Investors Strategic Bond fund. The views expressed above are his own and should not be taken as investment advice.