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Kate Beioley, Alex Newman and James Norrington survey the high-yield bond landscape in the search for income with as little risk as possible attached
April 15, 2016, Alex Newman and James Norrington

Bonds have an important role to play in a balanced portfolio. As well as offering a stable income stream, they have been negatively correlated with share prices throughout much of the last century-and-half. The basic concept of investing in a single bond is straightforward; investors receive a string of coupon payments and the par price of the bond at redemption.

In practice, most investors will buy a bond mutual fund where the managers will trade numerous (often hundreds) of bonds to make profits if prices rise and look to reinvest capital gains and coupons at the best rate, to achieve the highest total return. In a nutshell, bond funds offer a way to access a diverse mix of bonds for a low ongoing charge. Below, Kate Beioley outlines the current attractions of European high-yield bonds, Alex Newman looks at what retail bonds have to offer and James Norrington identifies the risks attached to various types of fixed-income investments.

European high-yield value

One area offering high income with what managers argue is an appealing risk/reward is the European high-yield market. High-yield bonds took a beating this year, but managers argue that European high yield has been priced for arguably unrealistic levels of European defaults, making it a potentially good value play amid expensive and low-yielding bonds elsewhere. With an economic recovery taking hold and fresh central bank stimulus pledged in March, backing lower credit quality issuers could be a worthwhile bet, particularly given the low income offered by assets elsewhere in the market. But the sector has already rallied, and with markets getting a taste for value investing again, it looks set to be a popular trade in 2016.

Between December 2015 and the middle of February, high-yield bonds experienced a dramatic sell-off – the average fund in the Investment Association Sterling High Yield sector lost 6.36 per cent between early November and mid-February.

Managers say that sell-off was too extreme. Rob Ford, portfolio manager at Twenty Four Asset Management, says: “The movement in high yield in January was a massive overreaction.”

“High yield was definitely very cheap at the start of the year,” says Morgane Delledonne, fixed-income strategist at ETF Securities. “And compared with the US high-yield market, European high-yield issuers are of better quality. European companies are continuing to deleverage, there is a better leverage ratio in the eurozone than the US and the concentration of energy companies is lower.”

Iain Stealey, portfolio manager of JP Morgan Global Bond Opportunities Fund, likes US high-yield too, but agrees that there are several reasons to back European over US high yield: “Recently US high yield was trading on a spread of 700 basis points over government bonds – indicating that investors can get an 8.5 per cent average yield. In our view, default risk has been priced in to the market and investors are being well compensated for holding US high yield on a risk-adjusted basis.

“But European high yield is even more attractive than US high yield on a fundamental basis and is yielding 5 per cent, which is all spread if you consider that the risk-free rate in Europe is effectively negative. European high yield has outperformed its US counterpart for the past four years; it remains earlier in the credit cycle and it will continued to be supported by an accommodative central bank.”

Stephanie Flanders, chief market strategist for UK and Europe at JPMorgan Asset Management, says: “If you’re going to take risk within your portfolio, where do you want to have relatively more risk? I would say high yield because high yield and riskier credit, unlike some of the equity market, is now priced for a recession. The spread on European high yield implies a level of default we just don’t think is there.”

She adds: “You don’t even have to believe that [default risk], you could just ask yourself ‘how do I protect my portfolio? How do I think about risk assets in an environment where we could see this further weakening or a recession?’ The answer might be to buy the asset that’s already priced for the bad news. Either things get better and you’re relatively better off, or if they don’t and then equities catch up to this story you will still be better off in high yield than in equities.”

Time running out

But there is a time limit. In March, ECB president Mario Draghi announced that the bank would be ramping up its stimulus to €80bn a month and would also for the first time be buying corporate (non-financial) credit as well as government bonds. The sudden increase in demand for investment-grade credit, now backstopped by the central bank, sent prices soaring. According to Bloomberg data, non-financial credit issuance in March was the third highest on record, reaching €49.5bn – just shy of an all-time high of €49.8bn.

On the day following the ECB announcement, European credit spreads for investment-grade and high-yield bonds tightened by 13 basis points and 46 basis points, respectively, according to ETF Securities, demonstrating the speed with which investors moved to buy the assets.

Between its most recent trough in February and today, The Bank of America Merrill Lynch Sterling High Yield index is already up by more than it fell in a dramatic slump between December 2015 and February 2016. But Mr Ford says that, for now, high yield is still looking well priced.

Ms Delledonne argues that spreads could get narrower still and that the volatility expected this year from markets could see more turbulence for the high-yield market, which could create opportunities. And even if this rally is running out of steam, with income so paltry everywhere else it could be the only option for anyone seeking yield.

“European high yield is still attractive given the spread on offer,” says Adrian Lowcock, head of investing at AXA Wealth. “Default levels are still low and high yield looks particularly appealing in a world of negative rates – with other assets you are actually paying someone to hold your money. There is still time to take advantage of the negative sentiment to make this contrarian bet, but there are still major risks and everyone is predicting a volatile year. The key is to make sure you are compensated for that risk.”

 

High-yield bond funds

For a European-specific high-yield fund, Mr Lowcock points to Threadneedle European High Yield Bond (GB00B894NV05), which has performed particularly well over the past 10 years, having returned 112.8 per cent. It holds debt in companies, including Gazprom, Unitymedia and Virgin Media. However, it has been highly volatile year to year. Mr Lowcock says: “Michael Poole runs the fund with a strong focus on stock selection, which is then combined with wider economic outlook and sector views. Any sterling exposure in the fund is hedged back into euros, so investors get currency exposure in the fund (although there is a sterling class fund).

“The fund is more conservatively run than many of its peers and has avoided peripheral debt and bank debt, which means it lags behind when confidence returns, but protects investors during market sell-offs, which we have seen in 2008, 2011 and more recently.”

Jason Hollands, managing director at Tilney Bestinvest, also likes the fund: “It is the only European high-yield bond fund on our rated funds list. Typically we would use a global fund for high-yield exposure,” he says.

M&G European High Yield Bond (GB00B7FS2455) has also beaten its sector and is yielding 4 per cent. It is mainly invested in BB and B-rated bonds, with 97 issuers at the end of February and pays out income quarterly. Unlike the Threadneedle fund, Russian energy giant Gazprom does not feature in its top 10 and the fund has a slightly lower interest rate risk, with its bonds mainly focused on maturities of between three and five years.

However, Mr Lowcock and Mr Hollands argue that choosing a high-yield fund not solely focused on Europe could be wise, retaining European exposure, but adding in other countries, too. Mr Lowcock and Mr Hollands both recommend looking to funds in the Investment Association (IA) sterling high-yield bond sector for exposure. That means funds are invested in predominantly sterling-denominated debt. This does involve currency risk, particularly with the upcoming EU referendum set to shake sterling. However, there are strong performers with exposure to European high-yield debt, which give good levels of income and capital appreciation.

Invesco Perpetual High Yield (GB00BJ04GF14) invests globally, but has a strong weighting to European debt. The fund invests in high-yielding corporate and government debt securities, as well as equities and is currently yielding 5.65 per cent. It aims to achieve a high level of income, as well as capital growth, and is able to use derivatives in order to smooth returns and generate income and has beaten its sector in total return terms over five years. It has returned almost 80 per cent in 10 years, compared with 61.4 per cent for the sector.

The fund’s three managers have been adding to companies amid volatility, but are wary of the economic situation and claim to be “focused on higher-quality companies that we consider to be default remote”. Around 40 per cent of the fund is currently allocated to bonds issued by banks, which they argue offer a good balance of risk versus reward.

Baillie Gifford High Yield Bond Fund (GB0030816713) also has a reasonable weighting in financial services, but is most exposed to capital goods, with its largest holding in BB and BBB-rated debt issued by companies including packaging company Ardagh Packaging. The fund claims to “invest in companies that will weather economic fluctuations rather than attempting to time markets” and it has performed well over time, delivering impressive capital growth and income. The team looks for underpriced assets, studying criteria such as industry background, competitive advantage and financial strength, setting credit milestones focusing on three to five years ahead. It has returned 89.1 per cent over 10 years and 30.8 per cent over five years with a current yield of 4.6 per cent, according to Morningstar. However, with a smaller number of holdings than many rivals (currently just 72), it can be more volatile than others. It is one of fund rating house FundCalibre’s top picks in the sector.

 

High-yield ETFs

Another way to play European high yield is by using an exchange traded fund (ETF), which will offer broader exposure to a high-yield index and the ease of getting out quickly, but will not give the same benefits of specific bond selection that a good manager could offer. There are several benefits to using a bond ETF, though, and inflows to these products are swelling to record levels.

ETFs are low-cost, offer broad-based exposure to fixed-income indices and, crucially, offer good liquidity because they are listed, trading throughout the day on the equity market. Liquidity is an issue with bond investing and the fact that investors are able to buy and sell ETFs easily on the secondary market without having to redeem the underlying assets makes them appealing, particularly as the industry grows in size and the cost of trading ETFs comes down.

The first quarter of 2016 was a landmark year for fixed-income ETFs, with record flows of $43.7bn into global fixed-income ETFs and $31.8bn into US fixed-income products – 21 March 2016 was the biggest fixed-income trading day ever recorded, according to iShares, across Europe, the Middle East and Africa, with inflows into investment-grade and high-yield corporate ETFs being used by investors following the ECB’s announcement.

The downside with ETFs in this area is that you are taking on broad exposure and cannot modify your exposure according to sectors or maturities you want to avoid. Unlike an active fund, there is no chance to mediate your exposure here to avoid sectors you may want less exposure to, such as energy, or avoid bonds with a higher interest rate risk. Although interest rates look set to remain lower for longer, exposure to bonds that mature a long time into the future still brings with it duration risk – the threat of your bond eroding in value if rates do rise. While an active manager can hedge against this by using derivatives or selecting different bonds, an ETF tracking the entire market cannot (see more about these risks further on in this article).

iShares Euro High Yield Corporate Bond UCITS ETF (IHYG) and the sterling version (SHYG) are the most popular European high-yield ETFs traded on the UK market and have expanded fast, making them highly liquid. The ETF tracks the Markit iBoxx Euro Liquid High Yield index, tracking euro-denominated non-investment-grade corporate debt. Unlike the active funds, this ETF has 462 holdings and is purely focused on Europe, with the largest exposure to Italy, accounting for almost one-fifth of the assets. It is one of the largest of its kind, with assets of over €4bn, making it easy to trade, highly liquid and so cheaper in trading cost terms. According to a Morningstar report last year, this is the best option of its kind for ETF investors keen to track high-yield corporate bonds. It is currently yielding 4.5 per cent and pays out quarterly dividends.

SPDR Barclays Euro High Yield Bond UCITS ETF (JNKE) tracks the Barclays Liquidity Screened Euro High Yield Bond Index. It is also highly weighted towards Italy and heavily concentrated in industrial stocks, which make up 90 per cent of its weighting. However, the index it tracks is designed to be a more liquid version of its parent and it has performed broadly in line with the iShares ETF. It has 325 constituents and is small at €248m, running the risk of wide spreads.

Finally, Lyxor UCITS ETF Eur Liquid high yield 30 ex financials (YIEL) is a more targeted ETF focused on a subset of euro-denominated sub-investment-grade liquid corporate debt comprised of just 30 bonds. It does not include exposure to banks, which carry higher risk in Europe as a result of negative interest rates squeezing their margins. But with small exposure comes a concentration risk, which could undermine the benefit of opting for a broad ETF index. It is also fairly small at €299m.

Keep the balance: core bond funds

Regardless of the appeal of high-yield bond funds, there is no doubt that they are a riskier play than other assets and should not be a large chunk of your portfolio or even your fixed-income portfolio. With so much potential for volatility, Mr Lowcock says you should split your portfolio into a set of “core holdings and then tactically take exposure to something like high-yield. Holding a strategic bond fund as a core fund is a good idea and then your appetite for risk will determine how much to put in high-yield and corporate bonds”.

Strategic bond funds have the benefit of being able to invest across the entire bond market, including high yield, government bonds and corporate credit depending on which sector the manager feels will outperform. Choosing a good strategic bond manager will prevent you having to put all of your eggs in one basket and enable you to continue earning returns if the macroeconomic climate changes.

James Yardley, senior research analyst at Chelsea Financial Services, likes Jupiter Strategic Bond (GB00B4T6SD53). He says: “It’s a ‘go anywhere’ fund run by Ariel Bezalel. He has a great degree of flexibility and will do a lot of hedging of the duration and the currencies among other things. In this environment where the central banks are diverging, this is the sort of manager you want, particularly in an environment when bonds are looking so expensive.” The fund aims for a high income and capital growth by seeking out the best fixed-income opportunities globally and invests in higher-yielding assets. The fund’s highest exposure currently is to corporate bonds, at over 60 per cent, closely followed by government bonds.

PFS Twenty Four Dynamic Bond I Acc (GB00B5VRV677) is a slightly different proposition as it invests in asset-backed securities along with the more common areas of government and corporate bonds. It has recently been hit, like high yield, by a turn in sentiment towards asset-backed securities (securities made up of loans against assets such as mortgages or credit cards), often perceived as higher-risk investments. The team has been adding risk to the portfolio in recent months, reporting in its most recent fact sheet that “credit risk has become markedly cheaper as markets rapidly positioned themselves for recession and questioned bank solvency”. The fund managers believe that economic weakness is “an earnings problem rather than one that leads to a material pick-up in the default rates (outside of the troubled energy and commodity sectors), or one that leads to bank insolvencies.”

Kames Absolute Return Bond Fund (IE00BVVQ0585) is arguably a lower-risk fund, aiming only to generate positive absolute returns for investors on a rolling three-year basis no matter what happens in markets. It invests across the range of bonds and is less volatile than many of its peers, although it does not perform as strongly as others in rising markets. Instead, it is designed to minimise volatility and protect against losses.

CQS New City High Yield Fund (NCYF) is an investment trust focused on high-yielding fixed income from small- and mid-sized companies and tends to buy securities higher up the repayment priority scale, reducing the risk that it will not be paid back. In 10 years it has beaten its sector average, delivering a share price total return of £201.5 on an investment of £100 compared with £193.6 for the average trust, according to the Association of Investment Companies.

Finally M&G UK Inflation Linked Corporate Bond (GB00B44JC482) “fills an important gap in the market”, according to FundCalibre, by offering protection against inflation, as well as exposure to higher corporate bond yields. While inflation does not look to be rising any time soon, fund manager Ben Lord believes that markets are unprepared if inflation does tick up. Recently the fund has been hurt by Mr Lord’s positioning for inflation, with rates tumbling last year. But with a short duration and derivatives strategy, the fund is a good holding to hedge against rising interest rates in the future.

Risks of fixed-income investments

Two of the most important reasons that bond prices change are the credit worthiness of the issuer and the bond’s sensitivity to interest rates. The first point is easily explainable, investors will pay less for a bond if they feel the capital is more at risk and will demand a higher yield as compensation for less certain repayment.

The relationship between bonds and interest rates requires more explanation. As rates rise, so do required returns. This means that the price of bonds with coupons below the new gross redemption yield (GRY) will fall, in order to match the rate demanded by the market. For investors holding a single bond to maturity, in a sense, the falling price on the open market doesn’t matter. After all, provided the bond issuer remains solvent, capital will be repaid and coupons issued, so they will not suffer a loss in nominal terms.

There are, however, some risks in this scenario. First of all, there is an opportunity cost as the investor could have waited and bought a higher-yielding bond with similar credit risk. Secondly, higher interest rates are likely to be in response to an inflationary environment. If the value of future cash flows is diminished, the investment may underperform in real terms.

In practice, most investors will use bond funds and it is in this scenario that price risk becomes more of a problem. The value of the units held are determined not only by income from coupons and redemptions but also the current market price of holdings. This means that falling bond prices seriously undermine total performance. Bond fund managers carefully monitor the interest rate risk in portfolios and the main measures of risk is the ‘duration’ of a bond. There are several factors that contribute to the interest rate sensitivity of individual bond prices, including the time until maturity, the coupon and the yield. The most reliable measures for composite risk are the Macaulay duration and the modified duration of a bond.

The duration devised by Frederick Macaulay is in effect the weighted average of present values of all of a bond’s cash flows. The duration is measured in years and the longer the duration, the more sensitive the bond is to interest rate changes. Bond fund managers will look to match nominal liabilities to durations in a strategy known as ‘immunisation’. As the Macaulay duration is the effective maturity of the bond, immunisation enables managers to try and take account of sensitivity to interest rates and ensure there is no capital short-fall as liabilities fall due.

An important point to note is that the duration of a bond is not the same as its time until redemption/maturity. For example, a five-year bond could have a duration of four-and-a-half years. It is the duration that managers will pay most attention to as an indicator of the bond’s risk.

The modified duration is another extremely useful measure of a bond’s interest rate risk. Its purpose is to estimate the percentage change in price in response to a 1 per cent movement in GRY. The modified duration is only an estimate, as the relationship between price and yields is not perfectly linear. Therefore the modified duration is adjusted by a measure of the convexity in the relationship between price and yield for a particular bond. In essence, knowing the modified duration of a bond is a bit like knowing the beta of a share – it is a measure of the price sensitivity of an asset you hold to changes in the market.

Liquidity

Another concern for bond managers is the ease with which an issue can be bought and sold in the open market. In certain market conditions, the volume of trading can concentrate into benchmark bonds or the most recent ‘on-the-run’ bond issues, this can render other issues illiquid.