Nicholas Trindade, fixed income fund manager at Axa Investment Managers, said he is “worried” about the investment case for high yield bonds right now due to the unusual market conditions.
High yield bonds should be the most economically sensitive part of the fixed income market as the companies borrowing in that part of the market have a higher propensity to default, and weaker economic conditions increase the chances of more companies going bust.
Meanwhile, higher interest rates would usually be viewed as a negative for high yield bonds because the yield offered by lower risk fixed income assets rises, reducing the propensity for investors to own riskier assets.
But despite those apparent negatives, the asset class has proved resilient over the past three years, outperforming the traditionally lower risk asset class that is UK government bonds, as table one, below, shows.
Jordan Lopez,, head of the high yield strategy group at Payden and Rygel, said that high yield bonds are a “short duration” asset class, so one of the typical ways in which fixed income investors diversify, through owning different parts of the interest rate curve, is not available.
But he said there is quite a divergence in terms of the spreads between the higher and lower quality ends of the high yield market, so this is a way to achieve diversification within the asset class.
He said the difference in yield could be as much as 600 basis points,
His general view is that high yield bonds have been resilient this year due to many businesses locking in the lower interest rates available prior to this year, and so not being impacted by the increase in base rates, and it is this which has kept default rates low and returns resilient.
Donald Phillips, fixed income fund manager at Liontrust believes the short-dated nature of the asset class is key to recent resilience of he price.
He said: "Because the average loan term is low, so too is duration – the level of bond price sensitivity to interest rate or credit spread changes.
While longer-duration government bonds might see a large price drop in order to reflect rising interest rate expectations, the impact of this discount rate change is smaller for short-duration bonds such as the typical high yield bond. In bond terminology, there is strong ‘pull to par’ within these short-dated bonds; while prices may dip below their par value, the short time to redemption at par will limit the extent of the deviation. By definition, these high yield bonds also have a high annual income level for investors. This means that it takes quite a large bond price fall to outweigh the income in total return terms and – as we’ve established – these bond prices tend to fall less when interest rates rise."
He added: "The same is true of periods of widening credit spreads – the extra yield investors require for lending to higher risk companies rather than low-risk governments. If yields are rising due to wider credit spreads (as opposed to higher central bank rate expectations) the price reaction is still determined by duration (albeit it may be called ‘spread duration’), which – once again – is typically lower for high yield bonds han other bonds."
