Peer group benefits from strong market rally as average portfolio returns 22%
The IMA £ High Yield sector has outperformed all other bond sectors over the last 12 months, with investors attracted by low interest rates and the strong market rally for most of the period.
Over 12 months to 2 August, the average fund in the peer group returned 22%, according to Morningstar. Over the same period, the UK Equity & Bond Income sector’s average fund delivered 16.3%, £ Corporate Bond 16.1%, £ Strategic Bond 16.9%, Global Bond 13.7%, UK Index Linked Gilts 8.4% and UK Gilts 7.6%.
Marlborough High Yield Fixed Interest is the top performer in £ High Yield over one year, up 35.2%. The worst performer over the same period is Scottish Widows High Income Bond, up 15.1%.
Philip Milburn’s £246m Aegon High Yield Bond is ranked fourth out of 20 vehicles in the sector on a one-year view with a return of 28.9%.
The manager believes economic uncertainty will lead to a rise in defaults, but from a lower base.
“Using Moody’s as a guide to the market, the average default rate through the cycle is in the 4% to 5% range,” he says.
“It is now forecasting around 2% or just below in a year’s time on a rolling basis.”
Milburn believes a rate between 3% and 4% is more likely, although he points out the annualised year to date figure is currently only around 1%.
“I think for some companies it has been a case of extend and pretend as banks could not afford them to default, or gave them a second chance,” he says.
Milburn believes slower economic growth in future will only lead to a slightly higher default rate. “We in the high yield market purged ourselves of a lot of the poor issuers in 2008 and 2009,” he explains.
The manager says this year has been a record year for high yield issuance on a global scale with over 140bn worth in dollars, 16bn in euros and a few billion in sterling year to date.
“There are plenty of opportunities and there is a good chance to just pick which deals you like, take profits in some of your secondary positions and rotate into preferred deals,” Milburn says.
He admits supply was very low in May and June when markets fell but says, since the recovery in July, supply has “come back on tap.”
“The market has still been disciplined in pushing back a bit on price,” he says.
“This is the perfect market for us when there is high enough volatility that there is discipline being shown, but low enough volatility that deals are still being done.”
Another strong performer in the sector is Henderson Extra Monthly Income Bond, ranked sixth over one year, with a return of 27.8%.
Co-manager Ben Pakenham says, year to date, default rates in Europe have been very low, with analysts widely predicting European high yield default rates of between 1% and 3% by the end of this year, a similar forecast to the US.
“The major reason for this is the refinancing markets have reopened, even for some of the poorer quality credit,” Pakenham says.
He believes the market volatility in recent months has been a significant issue for high yield.
“When the sovereign peripheral European concerns were really kicking off in April and May, the high yield new issuance market did shut down for a period of time,” he says.
However, the manager says it was encouraging that the market reopened “fairly spectacularly” in July.
“We have had a significant number of deals, partially due to the fact there was a backlog of supply which was due to come in the second quarter of the calendar year,” he says.
“The encouraging thing is that markets were still volatile at the end of June and beginning of July and yet the new issuance market managed to reopen even in that environment.”
Pakenham says there is plenty of supply within the high yield segment of the market as issuance continues at a healthy pace.
“I personally have got involved in only a third of the deals, which gives you an idea of how many there have been,” he says.
The reason he has avoided some deals is either because he did not favour the very short tenures on offer, or the option for management to pre-pay debt.
Meanwhile, an offering from Baillie Gifford has consistently delivered top-quartile returns within the peer group.
Donald Phillips’ £124m High Yield Bond fund is the top performer over five years, up 37.9% compared to a sector average of 24.3%. Over three years the fund is ranked second out of 18 vehicles, up 20.8% and over one year it has returned 26.9%.
Phillips says he would not be surprised to see default rates starting to go up again but also believes a double-dip recession is unlikely.
“We are yet to see fully the impact of austerity measures on consumption and unemployment so a lot of questions remain unanswered,” he says.
“We will get through the next few years with hardly spectacular growth, but we won’t go back into a double-dip scenario.”
Phillips notes there has been plenty of new issuance but says Baillie Gifford tends to avoid what he calls “the new issue bandwagon.”
He says: “Five deals can come in a week and there is a no way we can do enough credit work on what are quite often brand new companies to justify buying them.”
Although he has avoided most of the new issues, he participated in one by healthcare provider Care UK.
“It was a rare sterling issuance in high yield. Most issuances these days are in euros or dollars,” he says.
“We think the potential for more outsourcing in the NHS is quite realistic under the current Government, and Care UK has a decent national UK network to do that.
“It is not an overly leveraged business – it has four times gearing, came with a yield of 9.25% and has performed quite well since it has been issued.”
Another he liked was from International Personal Finance, which used to be part of Provident Financial in the UK.
Phillips says: “It lends to unemployed customers on a very short-term basis at high rates, and then borrows long term in the bond markets for seven or ten years.”
He describes the company as the “complete opposite of Northern Rock”.
“When Northern Rock went to the wall it was lending long and borrowing extremely short and found itself with a liquidity stress,” Phillips explains.
“These businesses lend very short, maybe even only for one month or two, and then borrow for the long term.”
He says the business works very well in the UK and has strong growth opportunities in Eastern Europe and Mexico.
The issue is a BB+ rated bond, but Phillips says it has come in with a yield which would compare to CCC-rated companies.
He says: “We think the market has a misunderstanding of the underlying quality of this business. It is very easy to just compare it to a Cattles or a differently managed business which has gone through a lot of stress.”
