Investors in the best-performing high yield funds have been receiving an annual income in the region of 10%. And all the indications are this will continue.
This level of income was accompanied by average capital growth of 30% in the sector over the 12 months to the beginning of June – and in the case of at least one high yield fund, almost 50% – although this should be viewed in the context of recovering ground lost during the worst of the financial crisis.
In a low interest rate economy, in which the Bank of England base rate has been pegged at 0.5% since March 2009, the appeal is obvious. Consider the failure of equities to make sustained upward progress and the less than exciting yields delivered by government bonds and ‘investment grade’ corporate bonds and high yield begins to look very attractive indeed.
Like virtually every other area of the investment world, the high yield sector has felt the ripples from the sovereign debt crisis in the eurozone. With the very real possibility of a government default in Greece, investors turned their backs on what were perceived as riskier assets.
Inevitably, that had an impact on high yield bond issuance. The market was looking for more stable conditions and the shutters came down. New issues ceased for a month and only began again on 18 June.
Return to market
Companies looking for capital have now returned to the market. Indeed, with the exception of that month-long pause, macro-economic conditions have brought very healthy levels of activity to the sector over the past 12 months, with indebted firms turning to high yield bond issuance to plug the funding gaps resulting from a large-scale reduction in lending by the banks.
Coupons are looking attractive. In June, two of the world’s leading car hire companies, Europcar and Hertz, went ahead with successful issues, paying just over 8.5% and nearly 10% respectively. And across the Merrill Lynch European Currency High Yield Index, the average yield is in the region of 9.5%.
Rewards like these look particularly appealing in comparison with the returns offered by government bonds. Risk-averse investors seeking a safe haven have piled into the likes of US treasury bonds, depressing yields – and spreads for high yield notes against government bonds are now in the region of 800bps, well above the long-term average.
Clearly, then, investors are being paid well for the elevated risk associated with high yield bonds. What, though, is the reality of that risk?
Advantages
Prudent investors will always seek exposure though a specialist fund. The best of the teams managing funds in this sector have the experience and resources to identify firms offering the right balance of risk and reward. And holding a portfolio spread across companies, business sectors and geographical regions provides all-important advantages in terms of diversification.
No-one would dispute that at a macro level the economic picture is looking challenging. But at company level, particularly among industrials – one of the mainstay sectors in terms of high yield issuance – the evidence is significantly more encouraging.
After a cyclical low in the first quarter of 2009, company results have continued to improve and are now looking significantly healthier than many forecasters led us to expect.
Opportunities can be found in everything from South African food manufacturers to Spanish bingo halls. Indeed, Madrid-based gaming multi-national Codere has proved a highly attractive holding. The company – which manages bingo halls, slot machine arcades, casinos and racetracks in Europe and Latin America – is a strong one, with healthy geographical diversification and promising joint venture projects, and is delivering investors a yield of more than 10%.
Banks represent 20% of the Merrill Lynch index, but many managers would feel nervous about that sort of level of exposure, when they are not totally clear about what may still be lurking on their balance sheets.
Appeal
Of more appeal are trusted, if less than glamorous, names such as Derbyshire-based Eco-Bat, which is the world’s largest producer of lead and has consistently paid a highly attractive coupon. High barriers to entry for would-be competitors and a very strong management team more than make up for the volatility that comes with any investment in commodities.
Crucially for investors in the high yield sector, levels of defaults, when companies miss interest payments, are looking very encouraging. Grim predictions that defaults would reach 20% as the downturn took hold were never borne out in reality, even in the worst of the crisis. This month they are likely to return to around 5%, which is the long-term average.
Cost-cutting
Companies have managed to cut their costs significantly and they are managing to roll over their debt and, where necessary, renegotiate the terms of bonds with holders. The net result is forecasts of defaults falling to about 2% by the end of the year, which can only be viewed as a benign environment, particularly in view of the yields on offer.
With low levels of defaults, highly attractive yields and the likelihood that drastically reduced bank-lending to companies will make 2010 a bumper year for new issuance, high yield continues to offer plenty of opportunities for investors.
While no-one should forget these bonds pay higher coupons specifically because of the increased risk associated with them, it should also be noted that at current levels investors are being well rewarded for this. And in the current climate precious few other investments offer an income to match the 10% that has been delivered by the strongest-performing high yield funds over the past year.
It is worth emphasising shrewd investors will ensure they gain exposure through a well-managed specialist fund with a proven track record and a widely diversified portfolio. On that basis, high yield bonds are certainly worthy of consideration for anyone building a balanced portfolio.
Paul Reed, manager of the Marlborough High Yield Fixed Interest fund
