High-yield is rallying but keep an eye on the credit cycle

In the past month several Governments have dangled a carrot or two in front of income-hunters, in the knowledge they have debts to fund while investors are still on the look-out for reliable coupons:

• Belgium issued €100 million of 100-year bonds with a coupon of 2.3%
• Ireland issued €100 million of 100-year bonds with a coupon of 2.35%
• The UK issued £4.75 billion of 50-year Gilts with a coupon of 2.5%
• Argentina issued €16.5 billion in three, five, ten- and 30-year bonds, with yields ranging from 6.25% to 8%

Demand was strong and the paper snapped up despite the palpable risks:

• Duration risk is high with the British, Irish and Belgian paper, given the long life-span of the bonds
• Inflation risk is high, as central banks strive to stoke it. Coupons of 2.3% to 2.5% will look pretty unappealing if the European Central Bank and Bank of England ever reach their 2% target – or overshoot it.
• The UK last defaulted in 1672 (although it did tinker with the terms of the War Loan in the 1930s) but Ireland needed an EU and IMF bail-out in 2010 and, according to The Economist newspaper, Argentina has defaulted on its creditors eight times since 1824, most recently in 2001 and 2014. For all of the market’s enthusiasm for the reforms launched by new Prime Minister Mauricio Macri, he is unlikely to be in power ten or 30 years hence.

Only investors can decide whether the risk-reward profiles are suitable for the portfolios they are husbanding.

In the short term, those risks will appeal to some, especially as the Bank of England and US Federal Reserve are not dashing to raise interest rates and Japan and the Eurozone may seem the monetary authorities cut them further. Yet none of us has a crystal ball and the long-term risk to capital posed by inflation is clear for all to see.

If investors do feel comfortable moving up the risk curve in a quest for higher coupons, then corporate debt and high-yield debt may be areas to research further, but only in the knowledge that neither may be suitable for those of a nervous disposition.

The good news is there a good selection of global, UK and US high-yield bonds funds, although Eurozone assets are less well served, as there are just two Aberdeen Asset Management collectives from which to choose, should investors feel this is an appropriate path to take.

Best performing Global High Yield Bond OEICs over the past five years

Source: Morningstar, for Global High Yield Bond category.
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Best performing GBP High Yield Bond OEICs over the past five years

Source: Morningstar, for GBP High Yield Bond category.
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Best performing US High Yield Bond OEICs over the past five years

Source: Morningstar, for US High Yield Bond category.
Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

There is no investment trust dedicated to this area and although there are several exchange-traded funds (ETFs) that specialise in US, European or Global high-yield debt only one – iShares Euro High Yield Corporate Bond ETF – has a five-year history. iShares is the leading player here, but PIMCO and State Street also offer products.

High yield debt – a reprise

For less experienced investors, it may be worth quickly revisiting what high-yield (or “junk”) debt is.

The technical term is non- or sub-investment grade debt and this is tradeable debt (bonds) issued by companies that carry a rating of BB or lower from agencies Standard & Poor and Fitch or Ba or lower from Moody’s.

Generally, these are firms with a lot of debt and potentially troubled operating models where there is a higher risk of default, either through the non-payment of a coupon at the pre-agreed time in the pre-agreed size or the failure to return the investor’s principal (or initial investment) in full.

Owing to this risk, “junk” debt tends to come with a higher coupon that investment grade corporate debt or sovereign (Government) debt, as the issuers need to tempt in buyers with the prospect of better returns.

Looking at it the other way around, investors should demand a higher coupon to compensate themselves for the additional risk they are taking on (assuming this is a risk they are prepared to take, which may not always be the case).

Source: Moody’s, Standard & Poor’s, Fitch
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Junkyard rally

Bonds overall struggled a little in 2015 as markets wrestled with the concept of the US Federal Reserve’s first interest rate increase in nearly a decade (something that came to pass in December), but enhanced Quantitative Easing programmes in Japan and Europe, as well as a cooling of the Fed’s ardour when it comes to further monetary tightening, have given sentiment a fresh boost.

Bonds’ performance by sub-asset class, 2015 and 2016, in sterling terms

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

While the surge in equities and commodities may have garnered most of investors’ attention this year, junk bonds (and emerging market sovereign and corporate debt) have staged an equally spectacular return to favour. Prices have bounced and yields declined.

US junk debt has rallied hard in 2016 ....

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

... and so has emerging market corporate and sovereign debt

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

A further factor may be at work – and that is oil. While this seems counter-intuitive, as a surging oil price would normally be seen as inflationary and bad for bonds, on this occasion it has been seen as good news.

This can be seen most clearly as the riskiest, junkiest end of the spectrum, paper rated CCC and below, and the correlation between price/yield and crude.

The correlation between oil and the most lowly-rated debt remains high

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Fledgling oil explorers, notably those in the US, have enthusiastically issued debt to fund their drilling. In its thirst for yield, the market snapped up the paper but oil drillers have begun to default – Energy XXI, Ultra and Midstates are just the latest names to do so, while coal giant Peabody has also sought protection from its creditors.

Ratings agency Standard & Poor’s has noted that 45% of this year’s defaults are oil-related while rival Fitch point out the default rate on junk debt issued by oil firms is already running at 13%, against an overall US corporate default rate of around 3.9%.

Any investors fishing around for income are clearly correct to demand high yields from this area, given the risks and someone, somewhere has clearly been tempted, given the rally in yields and prices.

Caveat emptor

This is a clearly a specialist area, though, and one that must be approached with caution, even by the most skilled fund manager. Default rates are rising in the energy space – and the bad news is not restricted to this one area. If 45% of defaults are oil related, according to S&P then 55% are not and retail has seen a lot of US firms file for Chapter 11, including American Apparel, Radio Shack and Quiksilver, so would-be buyers of junk debt, or junk debt funds, need to look at more than the price of a barrel of oil:

• The ever-informative Wolf Street website reports that the American Bankruptcy Institute noted a 24% year-on-year jump in corporate defaults in the first quarter, the first increase of any kind for more than five years and a 9% hike in Chapter 11 filings.
• In the UK, the Begbies Traynor Red Flag index noted a 20% jump in the number of British manufacturers who said they were in significant financial distress and a 23% increase among financial service providers – and that despite the benign impact of a weaker pound, an economy apparently growing at around 2% year and a record-low Bank of England base rate.

America’s Big Four banks – Wells Fargo, JP Morgan, Bank of America and Citigroup – all noted an increase in loan impairment charges related to energy in the first quarter. The Big Five in the UK also revealed a leap in loan losses, with HSBC fingering energy as a particular source of additional charges.

Between them the Big Five took just over £2 billion of loan impairments in the first quarter of this year, more than double the figure recorded in the January-March period in 2015.

Source: Company accounts. Excludes Lloyds' loss on enhanced capital notes buyback.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

None of this is to say junk debt – or investment grade corporate debt – is a bad investment idea in itself. But it does flag the risks and emphasises both the value that a skilled fund manager in this area can add, aas well as the importance of ensuring the yields on offer fit with your tolerance for risk.

Default rates are low and big increases are at least partly priced in but investors will need to take a view on how high they may go (as well as the oil price’s direction of travel) before potentially taking the plunge.

Russ Mould
AJ Bell Investment Director