Hermes’ Jackson: What you need to know about yield in the current environment
12 December 2017
Hermes Investment Management’s head of fixed income Andrew Jackson outlines why investors can’t just look at the headline yield and must delve deeper to find value.
Investors need to look beyond the headline yield of bond funds and focus on the credit spreads, interest rate sensitivity and default risks, according to Hermes Investment Management’s Andrew Jackson.
The head of fixed income said with interest rates near all-time lows and the yields of many asset classes following suit, investors could be accused of focusing on the largest headline yields rather than the underlying fundamentals.
“The starting point – and I would say this as I have made a career out of it – is that it is a little more complicated than ‘what is the yield’,” Jackson said.
The headline yield is fundamentally comprised of two parts, he explained: the credit spread and interest rates, which have been extremely supportive of markets since the financial crisis.
“We have moved on from a situation where interest rates were at relatively normal levels – and normal means different things in different parts of the world but for the UK and the Bank of England it might be perceived to be in the 2.5-4 per cent range,” Jackson said.
Indeed, as the below chart shows, interest rates fell sharply throughout the 1990s but stabilised until the financial crisis of 2008.
UK interest rates since 1971
Source: Trading Economics
It is not just in the UK where this has happened, with a similar phenomenon in the US and Europe as well, though the Federal Reserve has begun to raise rates while the European Central Bank appears some way off.
“So what we’ve seen since the financial crisis is a significant reduction in yield which has meant a significant gain for those investors holding higher quality paper just because of the rates element,” Jackson noted.
The biggest beneficiaries of this have been the sovereign and investment grade corporate debt funds, which have a lower credit spread.
Traditionally, investors could expect the spread element of investment grade credit to be somewhere in the 100 to 200 basis point range above sovereign debt, meaning the interest rates comprise a much more meaningful part of the yield.
However, he warned that this tailwind will not happen again in the next decade as there is little room for rates to fall to the same degree as they have done in the past.
The head of fixed income said: “It is something that won’t recur over the next 10 years because it is not possible for interest rates to tighten by 250 basis points from here.
“Clearly several years ago one might have said it was not possible for interest rates to go below zero but we have proved that isn’t the case as rates have been below zero in some parts of the world.
“But it is not possible for interest rates to be contemplated at minus 2.5 per cent, so we won’t see that rally in bond terms as a result of interest rates.”
In contrast, for high yield bonds a historical normalised level of yield would be around 7 per cent of which historically interest rates have made up 2.5-4 per cent.
The remainder comes from the credit spread – something that has become more important for investors now the end of the low interest rate cycle has begun.
“I would think the right way to construct a credit portfolio now would be in the first instance to look at credit spreads and look at the amount of spread you are being paid versus the amount of risk that you are taking on,” Jackson (pictured) said.
“That risk comes in a number of forms. Clearly when we are thinking about credit we are thinking about default risk.”
Default risk for investment grade corporate bonds is usually relatively low as these companies very infrequently default and therefore the credit spread is lower while for high yield bonds (formerly known as junk bonds) the risk is much greater.
“If you were to do a statistical analysis of the amount of risk measured any way you want – default risk, market risk etc. – being taken versus the headline yield there is a very high correlation between those two,” he said.
“That being said, if you were to look in the same space – so two managers in the high yield space who are selecting from the same portfolio but one has a higher yield than the other that does not necessarily mean that the one that has more yield is going to perform worse.”
Performance of fund vs sector over 10yrs
Source: FE Analytics
For example, 10 years ago the £908m Kames High Yield Bond fund had the highest yield in the IA Sterling High Yield sector of 8.64 per cent, yet it has made a top quartile return of 92.84 per cent over the period, as the above chart shows.
Jackson concluded that, moving forward, investors are going to need to ask how much risk they are willing to take on and whether they want to invest in high yield or investment grade.
“One big area of debate recently has been that we have seen a very meaningful push on investment grade credit spreads – i.e. spreads have continued to tighten while high yield has stayed relatively stable – and that is unusual at this stage of a credit cycle,” he said.
“We normally see compression being the last leg of a credit rally. High yield spreads moving closer to investment grade spreads as people tend to have a higher appetite for more risky products in rallying markets.”
As this has yet to occur and interest remain low, Jackson said high yield bonds may look more attractive as there are still pockets of value for investors to exploit.
“It is definitely the case that there are areas of the high yield market that don’t represent good value on a historical basis. But there are pockets of equity land or sovereign debt or investment grade where I would suggest there is little or no value,” he said.
“I don’t think we are yet where you can take a broad brush and say the whole of the high yield market is overbought and undervalued. People need to think relatively to some parts of the equity market that there are areas that represent significantly better value.”
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