What is the story behind impressive returns?

Ashutosh Kumar analyses the performance of the IMA £ High Yield sector

The IMA Sterling High Yield sector has posted spectacular gains recently, attracting retail investors in droves. But, high yield does involve higher credit risk and that tends to suit a narrower audience only.

It was set up in September last year and is now home to 20 funds and up a magnificent 42% this year (to 21 September), according to Morningstar. To put this eye popping return in perspective, it is worth noting that high yield bond funds have significantly outperformed their US, UK and European equity counterparts over the same period in this market rally. However, the high-yield funds' returns over one, three and five years are moderate, 3-5%, reflecting the carnage in global stock markets that occurred between September 2007 and February 2009. In those times of extreme turbulence - not presuming that we are out of the woods yet but the investing environment has nonetheless improved since March - funds in the newly-formed IMA sector fell by just over 16%. As a result, their short- and medium-term figures have become somewhat muted.

But, the recovery seen this year is notably stronger than what we saw in 2003, which marked the end of the dot.com crisis. Over January-September 2003, the high-yield funds generated a 16.7% gain, which is a pretty good result but nowhere near the astronomical return produced recently.

So, what lies behind this divergence in returns? One of the main reasons is the disparity of returns between the higher and lower credit quality issues within junk bonds. Take, for instance, the ML Euro High Yield TR USD index which is up nearly 53% YTD (21 September; returns in GBP terms); in contrast, the ML Euro High Yield B TR USD index has risen a hefty 62% and the ML Euro High Yield CCC- TR USD index has surged a mighty 105%.

Erlend Lochen, who has run the Standard Life Higher Income fund since October 2004, points out the high-yield rally in the second quarter of 2009 was one of the strongest ever. He stated in his quarterly commentary: "Economic data showed tentative signs of improvement during the period, prompting investors to hope for an earlier-than-expected end to the recession." However, the strong technical nature of the rally did not necessarily mirror the fundamental picture faced by companies. It also marked a departure from market's behaviour in the first quarter, when there was a distinct difference between the performance of 'BB' and low quality bonds. He pointed out: "In the second quarter, even issues previously priced for default rallied sharply, and many essentially weak names outperformed the bonds of higher quality companies."

No doubt, the Standard Life Higher Income fund is not among the leaders in the 2009 uplift; its exposure to issues rated below B credit quality has been in single digits pretty much throughout this year. In contrast, the Invesco Perpetual Euro High Yield fund, which is ranked second out of 20 in the sector since the beginning of this year, has lower quality issues exposure running well into high double digits.

New money

Another factor fuelling the rise of high yield is a flood of new money coming into this sector since the peer group was set up last year. According to the IMA's funds flow data, net retail sales touched £570m since October last year; in fact, flows have been positive in all but one month (October 2008). Also adding to the cash needed to be put to work were coupon payments, which obviously in the high-yield funds' universe tend to be high. Furthermore, institutional buying of high yield has also been stronger, implying managers in the high yield space have had to deploy a fairly large chunk of money in the last 12 months.

Lochen pointed out: "Inflows of cash into funds from both retail investors and from bond coupon payments contributed to the high yield rally. This cash was then used to buy bonds in a market where there was limited supply. The subsequent dynamic of supply and demand led to some significant upward price movements, especially among risky, lower-priced bonds." Obviously, those funds whose managers chose not to participate in the rally in the lowest end of the quality spectrum and maintained a relatively high cash holding were forced down the league tables in 2009.

Another point worth noting about higher returns is the extent of decline seen during the financial crisis was notably deeper than what we saw in the TMT (technology, media and telecommunications) debacle. Over January 2000-February 2003, which marked the dot.com bear market years, the ML GBP High Yield index was down 4%. But, during the recent market downturn, the index fell by 15.6%, which is three times its previous fall. In general, the deeper the markets fall in the bears' grip the stronger is the bulls' pull. We saw that with high yield issues and it is also evident in the current equity market rally; every time there is a slight pull back in equity markets, the bulls see that as a buying opportunity and push the markets higher.

Risk-reward

As expected, the recent high returns have tended to accompany higher risk, which is measured on the basis of standard deviation of returns. The Standard Life Higher Income fund which has trailed in 2009 actually has a superior risk-reward profile over the last three and five years in comparison with its peers such as the IP Euro High Yield, Marlborough High Yield Fixed Interest and New Star Extra High Yield Bond (which is now part of Henderson Global Investors) funds. Needless to say, the three funds are among the sector's top five offerings YTD 2009. In fact, the New Star fund is among the riskiest over the last three and five years; so is the Marlborough offering over three years (this fund does not have a five year record). According to Morningstar, the Sharpe ratio (which compares two portfolios directly with regard to how much excess return each portfolio achieved for a certain level of risk) of the New Star fund is also negative over both three and five years, implying investors have not been adequately rewarded for the additional risk in the portfolio. Funds which have the highest Sharpe ratios in the sector over that period include the Standard Life Higher Income fund.

Linked closely to any fund's risk - both absolute and relative - is its manager's remuneration; even though high yield does involve higher risk the degree of it can vary significantly. If a fund manager's bonus is not tied to the long term performance of her their charge/s and if it is instead linked to, say, just one-year return which many a times is the case in the City then the manager is likely to take higher risk. We know in the case of New Star Asset Management, which folded earlier this year, fund managers generally took on excessive risk.

Caution

All that glitters is not gold - the mighty returns we have seen in this IMA sector in 2009 have proved to be a magnet for investors, but caution is warranted in terms of understanding the risk involved. Risk is not necessarily a bad thing; the issue is not all managers have the capability to make it work in the interest of investors consistently, over the long term. Therefore, lower risk investors ought to exercise caution before being sucked into the heady double-digit returns of high yield bonds we have seen recently.

Investors in high yield bond funds are a whole lot better now than they were before when funds in this sector were lumped onto another fixed interest peer group; while that has improved peer group comparison to a large degree, the sector is anything but perfect. The IMA includes those funds in this sector which invest at least 80% of their assets in Sterling denominated (or hedged back to Sterling) fixed interest securities and at least 50% of their assets in below BBB minus fixed interest securities (as measured by S&P or an equivalent external rating agency), including convertibles, preference shares and permanent interest bearing shares.

Given this definition, care must be taken in handling offerings such as the Aviva Investors Preference Shares fund which obviously invests in preference shares - and that is not high yield bonds. The other important differentiation among funds in this sector relates to the extent to which they are willing to delve into credit quality spectrum, and the IMA sector definition offers reasonable flexibility. As noted above, some managers will be reluctant to take on too much lower quality credit risk even though the decision may backfire from a returns standpoint. There is nothing ominous about those who do but investors ought to be aware of such a disposition as this can help train their expectations accordingly.