High yield is a good place to be invested in during an expansionary phase of the economic cycle, according to FE Alpha Manager Michael Scott, but not all agree.
The Schroders bond manager said that high yield’s performance has a higher degree of correlation to the expansionary stage, which he noted is the current stage of the economic cycle.
“During the expansion portion of the business cycle we would expect the ability of high-yield corporations to cover interest and principal payments to increase and be reflected in a lower risk premium through tighter credit spreads,” he said.
The current expansionary stage started around the third quarter of 2009, and to date the IA Sterling Extra High Yield sector is the second-best performing bond sector, behind only IA UK Index Linked Gilts, returning 93.72 per cent.
Comparatively, IA Sterling Corporate Bond is up 76.20 in the same period, while IA Sterling Strategic Bond is up 73.28 per cent, IA Global Bonds has gained 57.91 per cent and IA UK Gilts has gained 56.03 per cent.
Although there is much debate around whether we are nearing the end of the current stage of the cycle and are approaching the contraction phase, Scott is not forecasting an end at the moment.
However, when it does come around he said it would present an opportunity for active investors in the high yield space because security selection opportunities should increase going into the next stage of the cycle.
The below table shows that during the last economic slowdown, high yield outperformed other fixed income markets.
It should be noted that the timeframes included in some of the buckets are shorter in nature than Scott would necessarily agree with.
Indeed, the analysis provided incorporates the time period between February 2008 and January 2010 into the ‘recession’ time frame.
Asset class performance through the economic cycle
Source: Schroders
Scott said therefore that he would expect high yield to experience steeper drawdowns and volatility in a contraction stage of the cycle and acknowledged that a short-term investor would have to take into account such price fluctuations.
“We would expect periods of underperformance in high yield markets in times of contraction/economic stress as the default probability across the broad market rises and the search for safe haven assets increases,” he said.
Scott is co-manager on four funds including the £1.8bn Schroder ISF Global High Yield fund, which has made top-quartile returns in the past three, five and 10 years.
Another reason high yield is attractive is because it has generally shorter duration, M&G’s Jim Leaviss added.
“If you looked at a 10-year Walmart bond it might have a duration of seven years and that means that if government bond yields rise by 100 basis points, then the capital price of that Walmart bond will fall by 7 per cent,” he said.
“Whereas, a typical high yield bond might have a duration of 2 years, so it’s a lot less sensitive to sell-offs in government bond markets.” He added that when credit markets sell off, high yield markets could prosper.
Indeed, earlier this year equity as well as some bond markets experienced a sell-off after fears the Federal Reserve would hike interest rates quicker than previously thought.
Performance of indices over YTD
Source: FE Analytics
Leaviss also said that high yield protects you because of the cushion that comes with having a higher payout percentage.
“If your starting point is a yield of 5 per cent and you’re in this 2-year duration bond and you have a 100 basis points sell-off, you lose 2 per cent of your capital but you’ve got a 5 per cent coupon so you still make 3 per cent.
“You get protection and that’s what we have to think about,” said Leaviss.
At the moment, he said that default rates are low but noted that broadly CCC bonds should be avoided because the yields aren’t high enough to compensate for historical default levels.
However, he noted that there will always be great reasons not to invest in a high yield company, something which some fund managers and analysts never get and others do.
It might have too much debt, the prospectus might not look good or you might not like the markets in which it operates, but that’s why you get paid a higher yield, he said.
But Leaviss (pictured) said the returns are never as big as equities, so it’s as much about avoiding losers than picking winners in high yield. 
“I think avoiding losers in high yield is as important as picking winners because in bond world you have this asymmetry of return.
“It’s not like equity where you can buy Apple and it goes up a thousand times. You buy a high yield bond, you’re probably going to get $100 back and some interest, and that’s your upside.
“There’s occasionally some upside if you pick a high yield company that gets bought by a Walmart, a high-quality company, and you get a bit of upside there but your downside is the same, it can go to zero.”
Leaviss co-manages five funds at M&G including the £1.6bn Global Macro Bond fund, which has posted second-quartile performance over three, five and 10 years.
However, not everyone is as positive on the asset class, with Hermes head of fixed income Andrew Jackson offering a different opinion.
Although he has a positive outlook for the fixed income asset class, he said he doesn’t favour high yield right now.
“Would I buy a global high yield ETF right now? Probably not,” he said.
However, there were parts of high yield that Jackson did like including emerging market high yield corporates, which he described as “fabulous” and “great value”.
He added: “There are pockets that I like and there are pockets that I don’t like. European BB, on average, I like. US CCC, on average, I don’t like.
“I don’t dislike US CCCs because the corporates are awful, I dislike them because the leverage is too high. They’ve been given another opportunity to die another day and if defaults occur, recoveries would be poor, and they’ve also done super well this year.
“Year-to-date they’re up around 4 per cent – so, they’re 4 per cent less valuable than they were at the start of the year.”