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High stakes

The surge in high-yield returns has whetted appetites for an asset class that has historically delivered superior returns when global economies strengthen. With signs of economic and corporate earnings&#39 recovery in all major markets, coupled with a decline in the number of defaults, many investors greatly increased their exposure to high-yield bonds in 2003.

Those investors&#39 enthusiasm and the difficulty in finding yield in higher-graded debt have driven down the yields available in this asset class and narrowed the yield spread between high-yield and other bond classes.

However, the high-yield rally has only returned the market to what many observers would consider its fair historic market value. In this environment, we examine the prospects for high-yield bonds, explore their place in a balanced portfolio and discuss the need for thorough credit analysis to secure superior returns.

Market overview

Continuing strength in equity markets, particularly derived from growing earnings, will give investors confidence that funds for repayment will continue to be available and that a rising tide of cashflow will reduce the overall likelihood of defaults.

The market has benefited enormously from the year-long decline in defaults. The first nine months of 2003 saw 66 defaulting issuers worldwide, with total defaulted debt adding up to $30.3bn. Over the same period in 2002, 118 companies defaulted on $114.8bn worth of bonds.

Credit quality is still improving, as shown by the number of downgrades versus upgrades recorded by Moody&#39s, which shows a declining number of downgrades.

Major markets

The US high-yield market is easily the biggest in the world, worth more than $578trn and making up more than 88 per cent of the total world high-yield market. The benchmark Merrill Lynch US High-Yield Master 2 index rose by 28.15 per cent in dollar terms last year, buoyed by earnings&#39 recoveries and optimism over repayment prospects.

Beyond its size, the US is the most diversified high-yield market and is therefore less prone to swings caused by a single industry sector than are the high-yield markets in Europe and the UK. Market size is an important consideration for many UK and European investors, who might prefer to look for high-yield investment opportunities in a fund wholly or primarily exposed to the US market.

With a market value of £6.8bn, the UK now makes up 1.79 per cent of the global high-yield market. Although growing, its small size makes it difficult for investors to ensure that their high-yield exposure is sufficiently diversified. Over 2003, the UK high-yield market outperformed those in the US and Europe, generating a return of 39.45 per cent in sterling terms.

The European high-yield market is the world&#39s second-biggest, with a market value of e51.3bn, representing 9.34 per cent of the global high-yield market. Europe is a growing market but does not yet have the depth or immunity to knock-on effects from single-sector trends demonstrated in the US. Very few portfolios are likely to benefit from exposure solely to Europe at the expense of the US.

Prospects for highyield investment

With big price gains unlikely to continue, investors must now look to income as the main driver of total returns. High yield&#39s chief attraction is the high coupon rates on the bonds and, despite low interest rates, these remain among the highest available to investors. In a market at or near fair values, capturing this income while avoiding those issuers liable to default will generate the majority of the returns that investors will see.

High-yield bonds have historically provided annual returns comparable with those of equities while delivering slightly less overall risk. However, the market is subject to wide swings and, for most investors, should be used as an ingredient within their portfolio rather than a major component.

High yield is best at lowering risk within conservative bond-dominated portfolios. The high-yield market is correlated strongly with equity markets and high-yield holdings may not significantly reduce risk in equity-dominated portfolios. But for investors whose core portfolio holdings are government and high-grade corporate bonds, the reverse is true and directing 10 to 20 per cent of the port-folio into high yield can reduce portfolio volatility substantially while lifting returns.

Fidelity believes that careful bond picking will be the key to successful investment in high yield. We use more than 125 dedicated credit analysts to research more than 7,000 companies globally and supplement their work with risk assessment systems and regular face-to-face meetings with company management.

We share ideas with our global teams of equity analysts, who provide assessments of the earnings&#39 pros- pects of company and ability to repay.

Our teams are not only keen to identify strong credit stories that will result in a buy recommendation for the issuer but also want to single out issuers which are liable to be downgraded, as the negative impact of holding such bonds is disproportionately high.

Although this year is unlikely to see a rerun of last year&#39s spectacular returns, high yield is an asset class that many more investors should consider as a means of enhan-cing return and reducing risk within their portfolios. A growing number of opportunities are becoming available in the UK and European high-yield markets, many investors may also want to consider the US as a useful market to diversify their holdings.

A range of funds specialising in high-yield investment are on offer in the UK and Europe. Investors can choose between funds which offer a mix of high-yield and corporate bonds, single-market funds and even funds which focus on the riskiest end of high yield.

For advisers, Fidelity believes that the key factors when choosing a fund are suitability for the investor&#39s portfolio, quality of credit research and experienced management. Given those three ingredients, investors have every chance of successful portfolio diversification and enhanced returns.


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