Asset Allocator’s Soapbox: OPM's Ross Henderson

Ross Henderson, OPM Fund Management, looks at prospects for high yield bonds.

High yield bonds have provided investors with attractive, even exceptional returns since the credit crunch, but there are many reasons for believing that the asset class has much further to run. While many investors fear bonds are vulnerable in a rising interest environment, our belief is that the additional spread offered by high yield provides adequate protection.

Central governments appear likely to keep interest rates at low levels for some time, and perhaps longer than many originally envisaged. As a result, in a low interest rate environment, an income return from the high yield sector of more than 8% is an obvious attraction, and our feeling is they remain so even in a period of rising rates.

Historically, during and following recessionary periods, high yield bonds have performed better than equities, gilts or investment grade bonds. This was seen during the 1990s’ recession and following the bursting of the dotcom bubble.

Indeed, given the current economic position, the argument for high yield may be even stronger, as companies have spent the last two years reining in capital expenditure, and generally improving balance sheets via cost cutting and equity issuance.

While in some instances this may have caused harm to equity holders, it has in general meant companies have strong balance sheets and are more likely to fulfil debt obligations. Companies have been concerned about maintaining their credit rating and avoiding roll-over risk, and this has made for a very favourable backdrop for bond investors.

Traditionally, the main risk and problem of investing in high yield bonds has been the risk or defaults and the potential volatility. At present, the level of defaults is low and falling, and we are seeing fewer downgrades. Given the current outlook, it seems spreads are too wide, and we see further tightening over the next 12 months. This will increase the total returns from high yield via capital appreciation.

Fears of a double dip may well hit high yield bonds from time to time and its higher correlation to equity markets is likely to lead to some volatility, but in the current economic climate we may see more volatility in more interest rate sensitive bonds such as gilts and investment grade. Government bond yields are likely to swing between overbought and oversold as mixed economic data is released. Unless we see a return to dark days, like October 2008, then high yield is likely to outperform gilts over anything other than short periods. It may not be as the textbooks would say, but at the present time the traditionally lower risk fixed interest stocks could well be more volatile than the so called ‘higher risk’ high yield bonds.

It is hard to argue with the Bank of England’s scenario that the recovery is likely to be choppy and prolonged, and with this in mind we would avoid the very lower end of the credit ratings i.e. junk bonds. Our feeling is that value may well lie in the B and BB range where companies may well have strong enough balance sheets and cash generation to survive and fulfil their debt obligations. Given the risks still in the sector we would continue to hold a well diversified number of holdings via a collective fund.

One further benefit we see is that high yields bonds are often shorter dated than say investment grade bonds. This means that a fund manager will have within their fund a fair number of bond redemptions on an annual basis. This natural flow of monies from redemptions allows managers to reinvest in opportunities at present and maybe higher rates of interest. This gives the short-date high yield bonds some floating rate characteristics, which could be beneficial in a rising interest rate environment.

It can be argued that when interest rates do rise this is a sign that economic activity has improved, and therefore the risk of defaults has lessened. This would make high yield bonds more attractive and may well see spreads tighten.

Unless we see a severe double dip, we see high yield bonds as one of the most attractive asset classes, and even if interest rates rise they still offer more value than gilts or investment grade bonds.