Will riskier bonds start to outperform?

Back in April, we talked about corporate bonds being the opportunity of the century. Since then, credit markets have recovered nicely from their lows, so is the opportunity still available to investors?

With the trinity of central banks (Bank of England, European Central Bank, and US Federal Reserve) still supporting the market by buying both higher quality and some weaker high yield borrowers, and most companies looking to shore-up their balance sheets rather than pay money back to shareholders in the form of dividends, many believe it is.

“There is still a lot of fear, especially in the high yield market, which we believe presents an attractive opportunity from a total return perspective,” commented Kames’ Alexander Pelteshki. “To that end, while the upside in investment grade corporates is not nearly as interesting as it was six weeks ago, we see plenty of opportunities for cyclicals and what is perceived to be ‘riskier’ debt to outperform from this point.”

Fallen angels

Chris Higham, manager of Aviva Investors High Yield Bond fund, said before the crisis that the next decade would see significant growth in the high yield bond market. And this growth has been accelerated by the pandemic: high yield bond issuance has continued unabated in recent months, with almost $40bn in May to add to the $36bn in April.

In addition, the coronavirus and low oil prices have led to a surge in ‘fallen angels’ – companies downgraded from investment grade to sub-investment grade – amongst them well-known names such as Ford, Kraft Heinz, Renault and Marks & Spencer.

M&G says the fallen angel index isn’t for the faint hearted, but it can be profitable. “Initially, the risk of a fallen angel defaulting is actually higher than original issue high yield,” it said. “However, after a year or so, a fallen angel has a higher chance of becoming a rising star and return to investment grade. This is because fallen angels have several of the characteristics, such as size and industry type, required for an investment grade rating that other high yield issuers lack.”

Royal London Asset Management adds a word of caution: “CMA and Jaguar Landrover, two companies that were facing likely bankruptcy pre-Covid, as they couldn’t get new issues completed, have accessed government funding facilities at below market rates. Corporate moral hazard has thus already begun. We still think this is the lesser of two evils compared to even higher unemployment (both of these companies are large employers) but it makes us wonder if post-Covid this default discount will continue to exist for companies of this nature.”

Chris Higham added: “As opportunities increase, a healthy dose of scepticism will be required to achieve our objective of avoiding losers while generating an income.”

So, care needs to be taken when choosing which bond to invest in.

Finding companies that can adapt and thrive

Lucy Isles, co-manager of Baillie Gifford High Yield Bond fund, said that she always looks for companies that can adapt and thrive in any environment – but that the current situation is unprecedented. “What were previously viable businesses are struggling for sales, burning cash and taking on more debt in order to comply with lockdown,” she said.

“We’re still monitoring companies, as it is still the early stages of understanding the full economic impact of all this, but because we always have our eye on the resilience of businesses, so far we’ve only felt the need to divest one of our 73 holdings in our ‘post-COVID review’.

“Going forward, we’ll be looking at how companies can operate sustainably in the ‘new normal’ post-corona. Recent additions include Carnival, the cruise ship operator, which issued a short-dated bond with a 11.5% yield – there is some incredible value in the market.”

The co-managers of Invesco Monthly Income Plus agree: “For a long time, the yields in areas of our markets have been relatively unattractive,” they said. “But now things are in flux. We think there are bargains to be had and we are busy building yield into the fund – income streams that can be really valuable in the years ahead.

“In high yield we have added in small size to bonds we know well at cheap prices. We also added a couple of better-quality oil majors. But it is in investment grade where most of the activity has been so far.” The fund currently has just over half* of the portfolio invested in high yield bonds.

Richard Woolnough, manager of M&G Optimal Income is more cautious: “While we continue to favour investment grade over high yield, since the crisis started, we have found a number of attractive opportunities on a case-by-case basis,” he said. “But our high yield exposure remains relatively unchanged at around 19-20% versus a neutrality of 33.3%.

“One of the big questions that is yet to be answered is what type of recovery the world will see post Covid-19. Fiscal and monetary authorities will continue to support the economy, but it is unclear how the virus will evolve and how the current situation will impact companies and consumer behaviours. In this regard, we have been increasing risk in the portfolio since the crisis started, but we are certainly not going ‘all-in’, as uncertainty persists.”

Colin Purdie, chief investment officer for credit at Aviva Investors, concluded: “The greatest downside risk for high yield is the risk of recession, which is already underway. High-yield companies are not overly leveraged by historical standards, but the sharp contraction in economic activity will put many in serious financial difficulty. More broadly, the unexpected and extensive restrictions to economic activity have not given businesses time to adapt, and all companies’ profits have been hit.

“Investors should expect to see more defaults the longer the restrictions remain in place, but at current yield levels, our view is that long-term investors are being overly compensated for default risk in high yield, which could create an attractive entry point into the asset class. Finding companies in sectors where there is a relatively clear and stable picture over their prospects will be key to weathering this storm.”

To hear more about the opportunities in fixed income, listen to this podcast with Dickie Hodges, manager of Nomura Global Dynamic Bond.

*Source: fund factsheet, 31 May 2020.