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The outlook for high yield in a rising interest rate environment

In an economy with rising interest rates, high-yield credit is usually tipped to outperform government bonds and investment credit and three fund managers give their outlook for the sector. However, with many assets already valued at above redemption values, two managers outline the risks for the sector and a potential alternative option

The outlook for high-yield bonds

James Gledhill, manager of the Axa Global High Income fund

Global high-yield has performed well in 2013, at least partly because of its limited interest rate risk.

We remain positive, principally because we are relaxed with the main risk that high-yield does carry – that of default. The stance of central banks remains stimulative at this stage while economic news has been gently positive.

Also, while there is evidence of an increased willingness to take risk through the issuance of payment-in-kind bonds in the market, the majority of companies continue to be positioned fairly sensibly with regard to leverage.

For these reasons we see little in the macro- or micro-economic environment which is likely to cause an increase in unanticipated defaults from today’s low level.

Yields on global high-yield bonds are historically low but we live in a very low interest rate world. Credit spreads continue to reward investors well for current and anticipated default rates.

There is perhaps not the opportunity for significant capital gain from this position but the income yield is attractive and we see potential for positive event risk. 

IPOs look quite likely for a number of high-yield credits and M&A activity, such as Microsoft buying Nokia, has already been positive.

Technicals remain positive, particularly in the European market where demand has been robust all year and attractive new issuance limited. 

The US has a better range of issuance and demand is returning strongly after a mixed summer.

Our fund positioning and risk barbell remains longer in the lower-risk, shorter-duration bonds, balanced with an overweight in lower-credit quality bonds. 

We also continue to be underweight the dollar-denominated Latin America credits.

This is not so much a view on the relevant emerging market economies but a credit view on the quality of issuing companies.

Chris Higham, manager of the Aviva Investors High Yield Bond fund

We adhere to a high-conviction investment strategy, with the portfolio normally containing 60 to 75 holdings positions. 

High-conviction refers to our strategy of seeking only bonds which meet our specific investment criteria. Such companies can be broadly categorised as possessing strong business and financial risk characteristics with attractive yield valuations. We do not purchase bonds with a view to minimising risk relative to underlying benchmarks.

We see better value in selected higher-rated issuers on a risk-return basis. Therefore, most of our positions are single B or above. Furthermore, we currently have 20 per cent of our portfolio holdings in investment-grade securities, including top picks Mitchells & Butlers and Greene King, both UK pub operators. These contribute to a significant overweight to asset-backed securities which provide greater security and strong valuations.

Liquidity is a key determinant of fund performance. Holding liquid securities provides us with opportunities to lock in profits but importantly also allows us to potentially re-purchase the same bond at a discounted price when the market moves.

We hold strong positions in financials, such as Barclays tier one and Credit Agricole contingent convertibles. We like banks as they have improving risk controls and steadily shrinking balance sheets.

We concur with the Bank of England’s view that UK unemployment will remain elevated even as the economy grows and expect rates to remain lower for longer.

We remain positive on the outlook for high-yield but wary of potential pitfalls, especially within the eurozone. We expect demand to remain robust and default rates to stay low while monetary policy remains accommodative.

Martin Reeves, head of global high yield and manager of the Legal & General High Income Trust

The bulls may be winning over the bears. Global economic growth in developed markets is likely to become self-reinforcing, triggering a wave of optimism sufficient for investors to overcome concerns about slower emerging markets growth. 

If so, equity markets should rise and riskier asset classes, including high-yield, will do well. Growth will ultimately drive yields higher so interest rate-sensitive products will likely underperform – again to the benefit of high-yield bonds which benefit from shorter average maturities and higher coupons than investment-grade bonds. 

The trust is positioned for such an out-turn. We have more credit risk in the fund than in the benchmark index, implemented by biasing the fund towards higher-yielding parts of the market that are supported by the views of our macro-economists and credit strategists.

We favour B-rated bonds over higher-quality and more interest rate-sensitive BB-rated bonds and are underweight the US in favour of the UK, Europe and, more recently, emerging markets.

Having been wary of emerging markets for much of the year, we have added to positions in recent weeks, especially exporters, which are likely to benefit from a pick-up in global growth, and Chinese homebuilders, which offer attractive risk-adjusted yields.

We have for some time been overweight UK sectors such as retail, which have benefited from a stronger consumer, and this year have been adding to European exposures as political risks across the region’s periphery ease.

The only scenario where I see high-yield at risk of underperforming other mainstream fixed-income sectors is if we fall back into recession, which would spark an increase in defaults.

However, this is not our base case. Rather, we expect modest but improving global growth and subdued inflation.

If that is the case, high-yield remains an attractive addition to any portfolio because it is relatively lowly correlated to equities and bonds, it aids diversification and therefore boosts expected risk-adjusted returns for investors with both equity-focused and bond-focused portfolios.

The alternative view

Why convertible bonds or using put options might offer better options in the current environment.

Ben Helm, investment manager at GAM

In the past, high-yield bonds outperformed traditional fixed-income securities during periods of high interest rates because of strong economic growth and rising cashflows.

Today, however, the high-yield market faces two major headwinds.

First, a cash-generative recovery is by no means guaranteed, which affects the issuers’ ability to pay coupons and repay bondholders. Second, despite the recent stumble, high-yield performance has been exceptionally strong since the end of 2008, with the US high-yield market returning 143 per cent and the European equivalent gaining a phenomenal 159 per cent, including coupon income.

The rapid appreciation has pushed the price of many high-yield bonds above the value at which they will mature. Consequently, if investors move into the asset class at this stage of the cycle, they will be exposed to capital losses as their bonds approach maturity and also face significant call risk as high-yield issuers attempt to refinance before interest rates do indeed rise.

The strong performance has also created a volatile investor base, with many investors needing little excuse to exit the high-yield market and lock in what may be an unrepeatable level of performance.

Historical data confirms that the correlation between convertible and high-yield debt weakens as interest rates rise, and – more importantly – that convertible bonds have typically outperformed high-yield during periods of rising interest rates.

So why will convertibles triumph?

Short maturities mean that convertible bonds are less sensitive to changes in interest rates than traditional fixed-income securities. In addition, the equity component of a convertible bond is likely to appreciate in an environment when central banks are tightening monetary policy. This is widely known and has been an important driver of recent flows into the convertible bond market.

The key question is whether convertible bonds can maintain the strong level of performance they have delivered for the year to date and how this asset class will fare against other duration-light securities – most notably, high-yield corporate debt.

Considering that high-yield debt is already looking expensive, the anticipation of rising interest rates implies that convertible bonds are likely to continue to outperform. 

By virtue of their corporate link, convertible bonds are also exposed to the economic recovery – without sharing the asymmetric risk profile associated with traditional fixed income at this point in the rates cycle – and hence able to benefit from an equity market upside.

  

Fraser Lundie, co-head and senior portfolio manager at Hermes Credit

High-yield bonds have fallen by about four points since talk by the US Federal Reserve of tapering its stimulus programme spooked investors. 

The shake-out, which saw valuations decline from an all-time peak in May, affected recently issued BB-rated bonds the most.

Of the BB-rated bonds issued in the past 12 months, 56.4 per cent now trade below face value.

 Investing below par reduces the risk of capital loss, positions investors for future price gains and provides put options to benefit from buyouts as more companies – particularly those in the
US – consider M&A activity as they gain in confidence. 

According to figures from Bank of America Merrill Lynch, more BB-rated bonds issued in the past year are priced below face value than those issued in each of the past five years.

High-yield bonds usually offer change-of-control put options which allow investors to redeem at more than face value. 

This optionality further improves the potential for returns from investing in bonds below face value, as shown by recent trades that we executed in the US.

Crown Holdings, a metal-packaging company with leading market share in aluminium beverage cans, is the subject of persistent takeover rumours. 

We bought its bonds at 92 and acquired a change-of-control put which, if exercised, will value them at 101. 

This optionality is additional upside: the business’s strength and creditworthiness have made investors reluctant to sell its bonds below 90.

Lithium producer Rockwood Holdings has sold several businesses to focus on next-generation batteries, particularly for electric cars. It is now considered a target for a large investment-grade chemical company. 

We bought its bonds, rated BB+, at slightly above face value in anticipation of one of the following scenarios: it is acquired and its debt subsequently rallies; a buyout triggers our change-of-control put; or it is promoted to investment-grade status and its bonds appreciate.

Exploiting optionality is one of the relative-value techniques which Hermes Credit has applied for more than three years. 

As high-yield bond valuations remain generally high and liquidity is at its lowest level in a decade, we seek to manage these risks and outperform by investing globally among bonds and derivatives throughout the capital structures of issuers.

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