Many investors are bored stiff with high-yield bonds. With returns from bonds flattened from years of falling interest rates, it is an investment option that does not have the appeal that it once had.
But there is an argument that says now is the time to look at high-yield bonds as a way to diversify an equity-heavy portfolio.
Origen investment director Tony Lanning says investors need to consider high-yield bonds to broaden their portfolios but they need to be very stock-specific with their choices: “Fundamentally, most portfolios are overweight in equities in the overall asset allocation but when looking at bonds you need to be with stockpickers.”
He says it is a good time to make the move because most equities are presently not making huge amounts, so the transition may not be too difficult.
Hargreaves Lansdown senior analyst Meera Patel says she finds it hard to get excited over gilts and bonds, mainly because of the current interest rate environment. She says gilts and corporate bonds provide a cushioning when equity markets are turbulent and during unexpected external events but she does not think that investors should rush out just yet.
Patel says: “Once we have reached or are near the peak of the interest rate cycle, that is when gilts, the higher-quality investment-grade bonds, will start to look more attractive. At that stage, their yields should look more appealing and there may be many bonds trading below par with good scope for decent total returns.”
As for high-yield bonds Patel says these are more correlated to equities and less affected by movements in interest rates. She points out that high-yield bonds had a good run in terms of performance last year and generally have performed marginally better than equities in the year so far. The outlook is promising as default rates continue to fall and company fundamentals improve.
Even though equities have been affected by oil prices and interest rate rises to an extent, companies still need to make repayments on their debt regardless of the economic situation.
But Patel says: “Because the underlying fundamentals of companies continue to imp-rove, they are less likely to default and the risk taken for the yield on offer in high-yield bonds is also falling. This is not to say that high-yield bonds are low risk as they would still be regarded as higher risk but the levels of risk change depending on market and economic conditions.
Royal London Asset Management head of credit Eric Holt says: “High-yield bond funds are higher-risk fixed-interest funds, with behaviour more like that of equity funds than corporate bonds – for example, the volatility of returns is more like that of an equity fund.”
He says high-yield bonds add diversity to a portfolio and are viewed by many as a comfortable halfway house between equities and investmentgrade bond funds.
Holt says: “If investors are attracted to these funds by the higher-yield figures, presently around 9 per cent gross redemption yield, and do not appreciate the higher volatility of these funds, they could feel misused in times when they note negative returns so it is important to set expectations at the outset, and explain how these funds work.”
Holt says generally these funds have high weighting in sub-investment-grade “junk” bonds – generally from 50 to 90 per cent weightings, and they can often include other instruments in the fund portfolio, such as equities, swaps, derivatives and options. This means that investors should be aware of what the fund can hold as it will have a marked effect on returns and risk/return profile.
Lincoln Financial Group investment analyst Stuart Tyler believes using high-yield bonds as part of a collective investment scheme can give major benefits. He says: “A diversified portfolio allows risk to be spread so if a corporate bond should default or fail to repay either a coupon or principal, then the portfolio should not suffer significantly. This is particularly true of high-yield bonds where the risk of default is significantly higher than for investment-grade bonds.”
Credit Suisse Asset Management fund of funds director Robert Burdett says after many years of falling interest rates flattering returns from bonds, he believes investors now need to take care when looking at this sector.
“Although there are structural reasons supporting high yield at present, the prices of these bonds largely reflect this. Bonds are no longer a simple income story – in fact we don't think they have been for over a year now,” says Burdett.
CSAM has just completed its semi-annual bond review and has met with all the managers held and some key reserves and as an example of how to use bonds in the current environment.
Burdett says: “We are very comfortable with the majority of our holdings. In the last few weeks, we have also invested some of the cash balance as markets have come to price in most of the expected rise in interest rates this cycle.”
High yield has a place but Burdett believes that investors will continue to have to be more nimble in the bond sectors to make the most of their investments.
The high-yield bond sector is still one of the most under-utilised investment choices for retail investors. However, most commentators agree that expansion of its role in areas such as pensions and even fund of funds and multi-managers could help diversify most investment portfolios.