With company dividends being suspended and central banks cutting interest rates to virtually zero pushing corporate bond yields to all time lows, there seems few places for income-seeking investors to flee to.
One area that investors should consider, according to Liontrust Asset Management’s Donald Philips, is the high yield bond market.
Much of the commentary surrounding the high yield bond market involves a heightened awareness of default risk, potential for illiquidity problems, and the asset class is regularly referred to as ‘junk bonds’.
However, Phillips – co-manager of the $51.6m Liontrust GF High Yield Bond fund – said the risk of loss and liquidity in the sector can be better than that of small cap equities, which often suffer from illiquidity and highly volatile share price movements.
He said investors should recognise that – like any asset class – there are good businesses that produce returns and bad businesses that shouldn’t really be invested in, and that in the long run, risk-adjusted returns of the high yield bond market versus UK equities holds up very well.
Performance of IA Sterling High Yield vs UK equity sectors over 15yrs
Source: FE Analytics
Phillips said: “If you look at performance versus UK equities over more than a decade it produces similar results and much better risk-adjusted returns.”
The IA Sterling High Yield sector has made a 98.92 per cent total return over 15 years versus 103.83 per cent from the IA UK Equity Income sector and 122.84 per cent from the IA UK All Companies sector.
The key difference between UK equity markets and the UK high yield bond market is the predictable income stream that bonds provide, albeit with the risk of default.
However, many managers argue that their ability to exploit the benefits of diversification and active management helps limit the impact of any defaults.
Rhys Davies, co-manager of the City Merchants High Yield Trust and Invesco Enhanced Income Trust, said: “Having a diversified portfolio for a high yield fund is really important. That means having well over 100 different companies to diversify some of those risks.
“The reason for this I think is because, in theory, your upside is the new issue on a bond is the coupon, and that’s quite different to the downside which is potentially zero.”
Liontrust’s Philips takes this a step further by actively searching for idiosyncratic risk and trying to diversify away from thematic risk, avoiding large exposures to sectors and themes such as environmentally unfriendly oil firms, healthcare firms affected by politicised issues surrounding government spend, and defence firms that depend on potentially decreasing government budgets.
“Ultimately if you bet positively on a theme in the high yield bond market, you only ever get your money back, but if you get a theme in a cyclical sector, you can lose a hell of money,” he explained.
Therefore, he avoids sectors such as coal, oil and gas, mining and retail, focusing instead on finding high quality issuers within the high yield market.
He runs less than 5 per cent of the portfolio in CCC-rated bonds, and is overweight in BBB-, BB- and B-rated bonds, with some of its largest positions in bonds issued by Netflix, AT&T and Ziggo.
The advent of the Covid-19 pandemic means there is little debate that default risk has gone up substantially, and a lot of companies around the world have seen their credit ratings drop.
However, thanks to central bank intervention – which has included direct purchasing of high yield bond ETFs – many companies have been able to still tap the bond market for funds to weather the crisis.
Davies said the recent strength of the high yield bond market has been driven primarily by central bank involvement and stimulus, but there are real knock-on effects.
“It has meant that a lot of the stressed and distressed names have seen their [bond] prices rise and you could argue that some of those stress names have been lifted out of the danger zone for defaults,” he said.
David Ennett – Artemis Fund Managers’ head of high yield and manager of the offshore, $182.1m Artemis Short-Dated Global High Yield Bond fund – said the crisis has also sparked a change in corporate behaviour that has positively impacted the high yield market.
“Companies that previously were focused on share buybacks, M&A and capex [capital expenditure], are now focused on preservation of capital liquidity,” he said. “That's the biggest positive for high yield issuers.
“Companies have pre-emptively cut dividends, cut capex, employed more aggressive costs cuts, they’re not going to do M&A, and all these things that they’re doing to preserve liquidity, that directly reduces corporate credit risks.”
He believes that given where credit spreads are compared to historic levels, investors have a unique opportunity to capitalise on the asset class.
“History tells us every time the market [credit spreads] has been this wide in the past, which it has on many occasions, subsequent three-year annualised returns are quite strong, between 5 and 10 per cent.”
He said: “It never feels nice to buy high yield when you probably should be. Spreads are wide at the moment because the market is pricing that there is going to be defaults in certain industries, but that’s not particularly earth shattering and in high yield we’re kind of used to that.”
But Ennet emphasised that it was important to focus on “what is in the price” and that – from a credit point of view – certain bonds have been priced very attractively.
Indeed, in a somewhat contrarian call, the bond manager said he has bought certain bonds in the auto sector at 67 cents on the dollar with the view that while the auto industry volumes will be 20 to 25 per cent lower this year than last, the short-term credit quality of certain auto companies still look very attractive.