The arguments in favour of go-anywhere strategic bond managers allocating to high yield are familiar but powerful.
Default rates are in a historic trough, below 2%, thanks to low interest rates and the ease with which companies can refinance. And high yield also tends to be shorter duration, with average maturities between three and four years compared with five or six years for investment-grade bonds.
But perhaps the most compelling argument for strategic bond managers at the moment is the most worrying for their investors: that high yield has had an excellent run. Over the past three years the Bank of America Merrill Lynch high-yield index has risen by 10.9%, while the Markit iBoxx Sterling Corporates index is up by 5%.
‘High yield has done very and the managers are all trying to get to the top of the rankings,’ said Richard Carter, head of fixed interest research at Quilter Cheviot. ‘But when it’s at the top of its trading range, the last thing you want is high yield.’
Carter cites two concerns about the strategic bond sector: prices and correlations. High-yield bonds on both sides of the Atlantic change hands for around 5% above par, and there is limited scope for them to appreciate further due to the risk of them being called by their issuers. Equally, those high prices mean low yields – talk of the ‘asset class formerly known as high yield’ is already widespread. ‘At this stage in the cycle, you have to look at valuations,’ advised Carter.
Anxiety about high yield’s correlation to equities is creeping too – especially given that many strategic bond managers also carry plenty of equities. ‘If the stock market turns lower on the back of earnings disappointments, high yield will turn lower,’ agrees Chris Iggo, chief investment officer for fixed income at AXA.
Despite this many are sanguine, if not complacent, about high yield. Stefan Isaacs, deputy manager of the M&G Optimal Income fund, came back from JP Morgan’s annual high-yield conference last month surprised by ‘the almost total absence of discussion around some of the headwinds that it faces’.
Isaacs maintained that he was still ‘constructive’ on high yield, but felt this year’s returns would come predominantly from income rather than capital appreciation – ‘and may well look skinny versus previous years’.
Among the strategic bond managers, Carter favours the defensive – those who are cycling from high yield into investment grade and even government bonds. ‘That is a sign that the manager is doing the right thing,’ he commented. ‘You just hope that if you have a strategic bond fund, the manager is taking profits.’
The top two funds in Citywire’s Sterling Strategic Bond sector over the past three years – each having returned more than 40% through the period; their nearest competitor has delivered 35% – both run high allocations to non-investment grade bonds, but in markedly different ways.
The £883 million Royal London Sterling Extra Yield Bond fund, managed by A-rated Eric Holt (pictured), has produced 43.4% over the past three years and boasts a gross income yield 7.08% on its Z shares.
The bulk of its portfolio, 77.4%, is in high-yield debt and its largest holding is in B-rated 2031-dated Enterprise Inns paper carrying a 6.375% coupon.
Second place goes to the £851 million Artemis High Income fund, headed by the AA-rated duo of Adrian Frost and Adrian Gosden. They have returned 41.3% on a three-year view, with a present distribution yield of 5.2%.
Driving that performance has been their use of their equity allowance: 17.1% of the portfolio is in equities, with positions in the likes of HSBC. As Wealth Manager revealed last month, Artemis recently rejected switching the fund out of the IMA’s Sterling Strategic Bond sector.
The sector’s two largest funds are less gung-ho on the high-yield front. M&G Optimal Income, the £18 billion juggernaut steered by + rated Richard Woolnough, has just a 29.9% net weighting to high yield with a further 10.3% in equities. Half the fund is in investment-grade bonds and a quarter is in sovereign debt. It has returned 30.7% over the past three years.
The £3.9 billion Invesco Perpetual Monthly Income Plus fund has 17.1% in equities and 50.8% in high-yield bonds. Under AAA-rated Ciaran Mallon and the + rated pair of Paul Causer and Paul Read, it has returned 30.9% and has a distribution yield of 5.28%.