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Is the future bleak for high-yield bonds?

High yield bonds are continuing to deliver strong performance but fund managers are warning that the quality of issuance could slowly start to deteriorate.

As with other fixed income assets, high yield saw its share of challenges earlier this year as investors fled bonds amid mounting fears over tapering of the US quantitative easing programme.

EPFR Global figures show high yield bond funds across the globe recorded $6bn (£3.8bn) worth of redemptions during a single week in June. 

Irrespective of any bumps in the road high yield continues to perform well, with the Barclays Global High Yield index returning approximately 8.5 per cent between October 2012 and October 2013.

The Barclays US Corporate High Yield index has delivered a 7.6 per cent return over the same period, while the Barclays Pan Euro High Yield Ex Financials index stands out with returns of 16.1 per cent.

However, as prices in the market push higher, some are beginning to question whether the high yield market can appreciate much further, while others point to signs that leverage could be creeping up again in the sector.

With the current average price for high yield bonds at about 102, Henderson Global Investors Diversified Income Trust manager John Pattullo says: “It is quite hard to make capital going forwards.”

Rathbones bond manager Bryn Jones says while high yield will continue to benefit from a trend of low default rates over the near term, he is choosing not to add to high yield debt due to “current expensive valuations levels.” 

Bestinvest managing director Jason Hollands believes the high yield market has seen a rise in price due to a shift away from other bond assets that are more sensitive to the yield curve. He says: “At some point, when expectations are truly factored in that QE will start winding down, you could see quite a big readjustment in the bond market.

“On the back of that, investors have shifted away from areas that are most vulnerable to changes in the yield curve, and put more of their fixed income allocation into high yield. This has also meant prices have been driven up and yields have been squeezed in the high yield market, particularly on those shorter-dated issues.”

Baillie Gifford high yield manager Donald Phillips, co-manager of the £519.4m Baillie Gifford High Yield Bond fund, agrees. He says: “I don’t think you can expect much capital appreciation from the high yield bond market, certainly not at levels we have seen in the past couple of years.”

However, he argues opportunities can still be found for stockpickers to take advantage of what he describes as “rational” inefficiencies and mispricing within the high yield market. 

He adds: “For a variety of reasons there are inefficiencies in the high yield bond market we think we can take advantage of. Things should not stay mispriced for very long in this market but sometimes they do for quite rational reasons.”

In particular, Phillips highlights that large bond funds have to “ignore parts of the market that otherwise would be very interesting to them” because they are constrained by their own mandates or by the fact the company issuing bonds is too small.

As a result, the amount of research done on a particular company is therefore “very much reduced”, providing that stockpicker opportunity.

Pattullo draws attention to another potential risk, in that leverage is creeping up in the US and could well spread to other areas of the high yield market. He says: “The danger in boom times is companies might issue payment-in-kind bonds to pay themselves dividends. This is not a good indication because they are just leveraging up.

“There are signs now that some companies in the US are using proceeds, not to refinance existing bonds but to finance mergers and acquisition activity or pay themselves dividends.”

A payment-in-kind bond pays interest in additional bonds rather than in cash, so the company issuing the bonds will incur further debt to produce the new bonds required for interest payments.

Although this development has not yet spread to the UK and European high yield markets, Pattullo expects a steady rise in leverage and a consequent deterioration in issuance will become a “rolling trend”.

He says: “Generally, the quality of issuance is deteriorating slowly and leverage is increasing slowly. Next year will be more of a stockpicker’s market and, as leverage creeps up, there will be more slightly hairy deals, so we have got to be a bit more careful.

“We are not bearish. Broadly speaking, we have not bought an awful lot of high yield this year and we tend to buy old, reliable companies that we know rather than the latest vintage.”

Jones is also mindful of potential risks appearing in the high yield market. He says: “We are keeping an ear close to the ground for signals of financial stress or any meaningful deterioration in the quality of debt underwriting, at which point we would consider a material reduction in our exposure.”

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