Standard Life Investments' Higher Income fund is well-placed to negotiate market volatility through a strong emphasis on stock selection and meticulous research
With the leverage in high-yield bonds increasing and hedge funds making their presence felt in the market, what does 2006 hold for the high-yield investor? Erlend Lochen, joint manager of Standard Life Investments' Higher Income fund discusses bond market conditions for the year ahead and his focus on a stockpicking approach.
Corporate bonds have provided solid returns over recent months with long-dated bonds leading the way. In the fourth quarter of 2005, high-yield bonds also performed strongly. Market fundamentals remain supportive with demand still strong and companies reporting earnings either in line to better than expected. There is no sign of significant volatility, interest rates are low by historical standards and government bond yields are fairly stable. This backdrop suggests corporate bond spreads - the additional yield paid by a corporate bond above that of an equivalent government bond - are likely to remain at narrow levels and could even tighten further as strong demand for the asset class outstrips new issuance.
In the short term, some factors in high-yield bond markets are encouraging us to proceed with caution. Firstly, hedge funds are buying a considerable amount of high-yield stock and bringing with them a greater degree of volatility. While this is a technical issue, it is important to consider as it impacts on how much we weight investment in high-yield versus investment-grade opportunities. Secondly, we expect several new issues in the first quarter of 2006, which were previously scheduled for 2005, and this could have a negative impact on bond prices. Although we anticipate that high-yield bonds will perform well in the first half of 2006, an increase in supply or hedge funds 'leaving' the asset class could initially drive bond prices lower.
Another consideration is the level of default rates, which we expect to edge up, though the risks are sector and stock specific. The most obvious example is the auto sector and in particular auto suppliers to GM and Ford, rather than GM and Ford themselves. However, default rates are still at acceptable levels and balance sheet improvements are encouraging. In 1999-2001, when defaults rates among high-yield issuers were at 10%-12% (now at around 2%), telecom companies were 20 times leveraged and bond investors took 'equity' risk by funding such highly leveraged telecom companies. Today, most of them are around 5 to 5.5 times leveraged and, therefore, in a much stronger financial position. We expect default rates to rise to around 3% over the next year compared to the long-term average of around 4.5%. A greater consideration than default rates is valuations. If investors spot better opportunities elsewhere, high yield may sell-off.
The biggest threat to high-yield bonds is from US 10-year yields. The historical norm is for high-yield bonds to . the market when 10-year yields are rising. However, over the fourth quarter of last year this was not the case, as 10-year issues seemed immune to generally rising yields. US 10-year yields are currently around 4.5% and if they approach 5 to 5.5% then high-yield bonds may face a hurdle, however, our view is that they will moderate or even decrease from today's level. With banks more willing to lend, company leverage (a company's total debt vs profit) is also edging up across high-yield stocks, making the market more racy overall. While we do not believe leveraging levels will increase significantly from here, we expect it will be flat to up. There is, however, a silver lining; the level of leverage in the market tends to move in a cyclical fashion and when it is high it throws up some interesting investment opportunities in companies that should not have sold off.
Over the medium term, potential threats are outweighed by strong fundamentals. The market is still in a 'sweet spot' and new supply could create good trading opportunities in the first quarter. There is a lot of cash waiting to be invested so new supply should not derail the market. We will certainly be exploiting market moves to alter the level of risk in our funds. We also believe the economic recovery will continue, albeit at a slower pace than in 2005, which will be supportive for the corporate sector. This will encourage investors to take on more risk by investing in high-yield bonds. We believe the market should continue to experience volatility but there will be exciting stock-specific opportunities occurring for investors going forward. The ideal scenario for a high-yield bond fund is if 10-year US yields do not pass 5%, defaults remain within their current range, and managers achieve a successful balance between investing in high-yield and investment-grade bonds.
Securing the best, avoiding the worst
Our focus on stock selection is ideal in the current market environment. Our Higher Income fund is based on this approach and is consequently somewhat different from the majority of the more broad-based fixed income funds we manage. We see the management teams of as many companies as possible and invest in around 60 core companies at any one time. The Higher Income fund has some similarities with equity funds in the way that it comes down to stock selection and picking the winners and avoiding the losers.
Some of our recent stock picks include Wind, the Italian fixed line and wireless operator, and Cell C, South Africa's third-ranked cellular operator. Both companies are well positioned in their markets and have solid growth outlooks. Wind has been in existence for some time and has successfully cut costs and increased profitability. Meanwhile Cell C was formed in 2000 and has gone from negative profits to positive profits. Both investments were made in 2005 and we believe they are well positioned to perform during 2006.
Meticulous research is equally important when identifying the blow-ups. This focus has helped us to avoid several key market disappointments including the auto suppliers. We do not own Ford or GM (the auto production companies), however, we do own a position in GMAC (short maturity bonds), the finance arm of GM, which we expect to be partly bought out during 2006. The auto sector as a whole had a significant impact on the global high-yield market during 2005. GM had a profits warning in mid-March and then on the back of this, and little improvement in their outlook going forward, S&P and Moody's downgraded both Ford and GM. In the global high-yield indices, there are a significant number of auto suppliers, whose customers include auto manufacturers like GM and Ford. When GM and Ford are having a tough time the profit margins of these suppliers get squeezed a lot harder. We believe that going forward auto suppliers will continue to have a difficult time and, therefore, have no exposure to the sector with one exception, TRW. This company mainly produces safety products such as airbags, basically the type of equipment that can carry a price at a better margin. We would not expect this company to get squeezed the way the more commoditised suppliers do.
Waterford Wedgwood, the Ireland-based manufacturer of crystal and china products, is another stock where we are cautious about the underlying business. The company competes against far cheaper products produced in China and we believe that they have taken too long to introduce more contemporary product lines. Indeed the company announced in December that its first-half losses had widened to almost 100m (£67m).
Another crucial factor in managing the fund is to get the proper weighting in high yield. By weighting we mean the proportion invested in high yield versus investment grade. Within the fund, the weighting in high yield will most likely be between 60% and 90%.
This weighting has a significant bearing on the total return of the fund. One investment style for high income funds is to have less high yield but to hold long-dated investment-grade bonds. We do not believe this is a low-risk strategy as you are exposed to significant interest rate risk. Our approach involves holding a greater percentage of investment in high yield and a smaller amount in short-dated investment-grade bonds, which function more like a cash alternative with a decent yield but not much curve risk. The key driver for fund performance is, therefore, individual credit selection.
Key points
Reasons for short-term caution in high-yield bond markets.
Strong fundamentals out-weighing potential threats over medium term.
Achieving right balance between investment in high yield and investment grade. critical.
Focus on stock selection key in current environment.
