Junk bonds come off the scrapheap

Top multi-managers talk to Joanna Faith about the pros and cons of high yield bonds and reveal their favourite funds in the sector.

After a sluggish couple of years for high yield bonds, investor sentiment has started to shift. At the peak of the credit crunch, and for some time after, investors shunned the sector on the back of increased potential for defaults. But thanks to an improving macro economic environment and stronger corporate balance sheets, default risk has dropped and demand is on the increase. 

Meanwhile, with returns from cash, government bonds and investment grade debt so low, investors chasing yield are turning to junk bonds for answers especially as the threat of rising interest rates loom.

However, the sector is by no means a one way bet. Although the risk of default is less than it was in previous years, it has far from disappeared.

Cautionary note

David Thornton, investment manager at Premier Asset Management, says with the positive news potentially priced in, a cautionary note should be sounded.
“Investor demand has been extremely high in the hunt for yield and this has not been lost on some issuers,” he says.

“The return of some risky pre-crisis features in new issues has caused some commentators to express concern, notably payment-in-kind toggle bonds, where the issuer has the option to pay interest with further bonds rather than cash.”

Nick Marshall, manager of the Smith & Williamson Endurance Balanced fund, also urges caution. He says managers he has spoken to in the fixed interest sector have pointed out that while the asset class is attractive you need to be selective in which companies you back.

“High yield issuance this year has been underwhelming and one could argue that many of the more attractive companies have already gone through balance sheet restructuring so primary issuance must be analysed with care.”

Even so, high yield bonds have had a relatively strong start to 2011 with the IMA Sterling High Yield sector returning 3.5% year to date to 8 March.

Thornton says the sector offers a diverse range of managers and styles with different market outlooks to match.

He likes the Baillie Gifford High Yield Bond fund, which was one of the best performers in the sector last year.

The £146m fund has a new management  team led by Rob Baltzer that took over last summer following the departure of Ben Thompson. Thornton says it is a concentrated offering, focusing predominantly on the European market. It has historically taken significant off-index bets in asset-backed and non-rated securities, perhaps sacrificing some liquidity for potentially greater returns, the Premier manager says.

He also cites the Barings’ High Yield Bond fund, run by the group’s head of EMD research Ece Ugurtas along with one other manager and two analysts. The fund looks to achieve aggressive outperformance of the global high yield peer group.

“No doubt this fund is run by a talented fixed income manager. There is however a huge universe of credits to be covered by a small team,” Thornton says.

Rising interest rates

Meanwhile, Rob Burdett, co-head of Thames River Multi-Capital, is currently bullish on high yield.

“We hold it in preference to investment grade where we have zero exposure to dedicated investment-grade funds,” he says.

“With high yield funds we are exposed to an improving default rate and less exposed to the risk of rising interest rates and at the same time we are being paid a higher yield.

“I believe high yield managers can add stock selection value to potentially a greater extent than investment grade managers.”

Burdett currently holds the £330m Aegon High Yield fund run by Philip Milburn who has over 10 years experience researching and investing in pan-European high yield.