Do investors still need to take on high risk to achieve significant yields from bonds? Stuart Chilvers, Rathbone Strategic Bond fund manager, looks at the bond market and how he is positioning with bonds.
These days high yield bonds really do what they say on the tin: higher rewards, but accompanied by higher risk. With companies battling higher costs and a recession on the horizon, are the returns attractive given the chances of bond issuers coming unstuck?
Right off the bat, bonds are high yield for a reason: namely, they aren’t financially strong enough to be classed as investment grade. Given the tough economic environment, we expect many companies to start downgrading their earnings estimates. This is likely to present more of a challenge for high-yield issuers, who tend to be less financially secure or have more cyclical earnings. Debt affordability can become a problem for these companies much quicker than for their investment grade peers. As such, we can expect default rates to pick up in the high yield space, albeit this is from last year’s exceptionally low level.
One risk-mitigating feature of high-yield bonds is that they have a shorter average maturity than investment grade bonds, as investors tend to be less willing to lend to these lower-rated companies for longer periods of time (there’s more time for things to go wrong). As a consequence, when we compare high-yield bond indices to investment-grade bond indices, the duration tends to be significantly lower and hence less sensitive to moves in government bond yields. This meant high-yield bonds performed better than investment-grade last year as interest rates rose rapidly, despite their credit spreads blowing out by much more than their higher-rated peers.
However, with government bond yields trading somewhat sideways so far this year and central banks increasingly looking as though they are approaching the end of their hiking cycles, it is not clear that high yield will get this same relative benefit versus investment grade credit in 2023. The short-dated nature of high-yield bonds means that issuers must refinance bonds more frequently (at today’s higher prevailing rates), and hence feel the impact of higher yields much quicker than investment grade debt issuers. This year and next don’t look too challenging from a maturity wall perspective, but a significant volume of high-yield bonds mature in 2025. While we think central banks are approaching the end of their hiking cycles, we think the speed markets are assuming inflation returns all the way to target – and the rate cuts they are assuming – look optimistic at this juncture. Hence, debt payments for many high-yield issuer will likely balloon in a couple of years.
Quite a bit of risk, then, so what about the prospective returns? While high-yield credit spreads have widened recently, we believe that they aren’t big enough to make them attractive, given our concerns detailed above. When we compare them to investment-grade credit spreads, we don’t see the differential as sufficiently wide to compensate us for the additional risk we would be taking on. In other words, we get more bang for our risk by sticking with investment grade, in our view.
While there were times in recent years when investors had to take on a high degree of risk to achieve a significant yield from bonds, this is clearly no longer the case after a year of rapid increases in prevailing yields. We believe investors should pause for thought as to whether they are being sufficiently compensated for the risk they are taking. Times have changed: you no longer have to scrounge for yield.
While there will clearly still be some attractive specific opportunities in the high-yield market, on a general basis we prefer both investment-grade credit and government bonds with yields at current levels. We think relatively defensive positioning within fixed income makes sense, given we expect the economic environment to become increasingly challenging.
Any views and opinions are those of the investment manager, and coverage of any assets held must be taken in context of the constitution of the funds and in no way reflect an investment recommendation. Past performance should not be seen as an indication of future performance. The value of investments may go down as well as up and you may not get back your original investment.
