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‘Vested interests’ are deluding high-yield investors, Hermes warns
by Robert St George on Sep 18, 2013 at 09:37
Citywire A-rated Fraser Lundie, co-head of credit at Hermes Fund Managers, has argued that traditional approaches to high-yield bonds are outmoded and risk inflicting losses.
The Barclays Global High Yield index has gained a third over the past three years, far outpacing returns from sovereign or investment-grade bonds.
‘Too many people have a vested interest in an asset class that has gone up by 30%,’ claimed Lundie (pictured). He characterised their attitude as: ‘If it ain’t broke, don’t fix it.’
Lundie, though, perceived lurking dangers that could jeopardise that track record, which were not being picked up by other market participants.
The reason, he believed, was that the historic way of analysing high-yield paper – by reference to the spread it offered over gilts, treasuries or bunds – had been rendered obsolete by the flood of liquidity from central banks depressing sovereign yields.
‘On a pure spread basis you would say there isn’t a problem,’ Lundie observed. ‘But spread is only part of the valuation story.’
Rather, he focused on yield and price: they are currently at historic lows and highs, respectively. ‘It’s clear there’s a disconnect between valuations and fundamentals,’ commented Lundie. ‘We are at bubble levels that would never be picked up on a spread screen.’
The manager also recognised a more familiar source of anxiety about the high-yield space: liquidity. While the market’s size by value is now more than double its previous 10-year high, inventories are a quarter of their peak level.
‘This has been talked about because fund managers like to complain about it,’ Lundie noted. ‘But the convergence of a significant rise in the size of the market and a meaningful decline in dealer inventory could lead to a perfect storm.’
Within his own portfolio, Lundie has tackled this environment in three main ways. First, he has eschewed high-yield issues with call options, which represent three-quarters of his addressable universe. ‘They put a ceiling on where returns can go,’ he explained.
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