Charles Stanley’s Director of Asset Management, Chris Ainscough, discusses the place of high yield in a portfolio.
- While we prefer investment grade bonds for lower risk investors, high yield is still offering value versus equities in our higher risk portfolios.
- It gives a foot in both camps – potential upside if the economic environment improves, but potentially smaller losses than in equity markets if the environment weakens.
Income investors have gone from famine to feast over the past 12 months. Investors have a broader range of income sources available to them today than at any point in the past decade. When it is possible to generate an income of 5-6% taking little risk, do income investors need to take a risk on high yield bonds?
High yield bonds certainly have a superficial appeal. The Bloomberg US Corporate High-Yield Bond Index offers an average yield of over 8%, which puts it ahead of inflation and significantly ahead of developed market government bond yields, particularly at the longer end.
Equally, performance has been resilient after a tougher year in 2022. For the year to date, the average fund in the IA Sterling High Yield Bond sector is up 5.5%. For global high yield bonds, the average fund is up 2.7% (source: Trustnet, to 5 September 2023). Equally, while 2022 was undoubtedly tough, the sector showed more resilience than either equities or higher quality bonds during the downturn.
Nevertheless, there are caveats. Spreads over government bonds have come down significantly as investors have grown more optimistic about the economic outlook. This is particularly the case for US high yield, where the ICE BofA US High Yield Index Option-Adjusted Spread is 3.8%. These are levels not seen since May 2022, just as the Federal Reserve was starting its rate rising cycle. They are significantly lower than during previous periods of financial distress. During the Covid crisis, for example, spreads spiked to over 10%.
This has led to some concern over whether high yield bonds are making sufficient accommodation for a trickier market environment should recession finally materialise in the US, UK and Europe. A certain level of defaults is implied by current pricing, but how bad would it have to be to exceed those levels? We would agree that high yield doesn’t look cheap by historic standards and yields leave relatively little margin for error, but we still believe – selectively chosen – it has a place in a portfolio.
The high yield universe is in far better shape than during previous down cycles. The uncertainty created by the pandemic forced companies to manage their balance sheets and liquidity conservatively. This has not reversed even as the privations of the pandemic have faded, with margins, leverage and cash flow ratios all relatively robust.
There have been some signs of corporate distress at the margin. Data from law firm Weil Gotshal and Manges showed corporate distress among SMEs at its highest level since 2020, and there have been some high profile bankruptcies. The number of commercial bankruptcies increased nearly 17% in August compared to July, according to data company Epiq Bankruptcy. Equally, some high yield companies face significant refinancing risk. Having secured lending at low rates, some will face a cliff-edge rise in borrowing costs when their current borrowing expires.
However, weakness has generally hit the lowest quality companies rather than the majority of the high yield sector. It has also been confined to specific sectors, such as real estate and high street retailers with ‘old economy’ business models. As such, it has proved relatively easy for active high yield bond managers to swerve the weakest areas. With a stronger economic outcome in prospect, we remain neutral on high yield spreads, believing a drastic spread widening remains an outside possibility. Even if there is a widening in spreads, all-in-yields are sufficiently high to cushion some of the blow.
High yield versus equities
While we prefer investment grade bonds for lower risk investors, high yield is still offering value versus equities in our higher risk portfolios. It gives a foot in both camps – potential upside if the economic environment improves, but potentially smaller losses than in equity markets if the environment weakens. High yield is also less sensitive to interest rate conditions (because it tends to be shorter duration), so this can provide some diversification within fixed income.
Nevertheless, investors need to be selective. We have a higher weighting in BB rated bonds, believing this area is less vulnerable than other parts of the market should downgrades and defaults rise. We’re avoiding highly indebted and lower rated bonds. In terms of geographic allocation, there have been fewer downgrades in the US than in Europe and the UK, but spreads are wider in the Euro and Sterling markets, giving greater compensation. As such, there are opportunities in all markets.
There are certainly risks in the high yield market, which would be exacerbated by weaker economic conditions. However, this is mitigated by high yields, stronger fundamentals relative to history and the relative slow progression of the debt wall. Equally, when compared to equities, the size and duration of drawdowns in the high yield market is typically smaller and shorter. We still see a place for selective exposure to high yield bonds for higher risk investors.