It’s been a long time since an investment in a government bond has been about income, such is the nature of today’s extremely low and often negative yields. This artificial environment, accentuated by regulation and central bank policy, has also had a major impact on corporate bonds. Income-seeking bond investors may well feel as disappointed by the level of reward available from lending to companies as they do to governments.
That’s the bad news. The good news is that high yield corporate bonds remain a healthy source of income.
We think of it as an evergreen asset class; medium to long-term investors have tended to make positive returns, even when the starting point in yield has been lower than the long-term average. The following table shows the returns on a three-year investment in the market at previous low points in market yield. If an investment in a high yield fund can generate over 4% a year over the next three years, this is likely to look very attractive when compared with other investment options.
High yield is an excellent income generating asset class which is more blue chip than perhaps people give it credit for. The high yield bonds we own have a higher average market capitalisation than the FTSE 100 index. Due to its ‘junk’ nickname, high yield can often be approached with some reticence. This label stems from a period in the early 1990s when capital allocation was not at its most diligent, while also reflecting its technical classification of capturing everything that fails to make it into the investment grade categorisation. It doesn’t, however, chime with the positive developments in the asset class seen in the last 30 years.
Naturally, defaults are a part of the high yield market, as are occasional bouts of volatility. What’s important to remember is that high yield consists of a large pool of companies making interest payments (coupons), and these provide the vast majority of returns. In fact, over the very long term, more than 100% of the total return is income from coupons.
The following chart shows how the price element of the high yield return is affected by periods of market volatility and also tends to slide into negative territory over time as company defaults occur. However, the income component of returns tends to more than make up for this. Moreover, after the widespread concern over company dividends that were such a feature of the market volatility in 2020, its worth remembering that coupon payments, unlike dividends, are not optional and rank higher in priority for payment should a company run into difficulty.
While the high yield segment of the bond market promises an uplift on the anaemic income returns on offer from government bonds and much of the investment grade universe, it doesn’t mean accepting equity-like risk. The high yield market has a long track record of producing less than half the drawdown of the equity market. The following chart illustrates this point going back to the 1970s, with the notable exception of the period in the early 1990s when the market suffered a bubble.
While we have shown that the income component of high yield returns is paramount, the key to unlocking the best returns from the asset class is to avoid companies that default on their debts. We target a quality bias towards the more creditworthy borrowers through a combination of fundamental research of individual corporate bonds and avoidance of thematic, cyclical sector risks.
To judge whether a company’s bonds are an attractive long-term investment, our fundamental analysis looks at the following factors, which we call our PRISM framework:
- Protections – operational, the quality of the business and industry, and contractual, such as structure and covenants
- Risks - credit, business and market
- Interest cover, leverage and other key ratios
- Sustainability, of cash flows and environmental, social and governance (ESG) factors
- Motivations of management and shareholders, which is crucial in understanding the balance of interests and how this impacts creditors and is why you will find a large proportion of public market-listed companies in our Funds.
The high yield index can often suffer a negative risk bias: those companies and sectors that borrow the most also have a higher weight within the index. Heavily indebted sectors, particularly if they are cyclical, can represent factor risks within bond indices that shouldn’t be ignored in the name of managing index relative risk. For example, energy is a big component of the market (around 13% of the US index). There is a high correlation amongst all constituents to one external factor – the oil price. It is not good diversification, in our view, to run a passive or index-hugging portfolio on this basis. Instead, we believe that seeking out companies with idiosyncratic risk and avoiding large accumulations of thematic, cyclical risk is the best way to achieve good long-term outcomes within high yield.
In summary, large parts of the fixed income spectrum are simply too expensive to justify investment. High yield offers lower yields than it has done historically, but we believe it can earn investors a decent relative return in the years ahead. For those who can accept some volatility – albeit much less than equity markets – in return for enhanced expected returns, perhaps high yield bonds offer the answer.
Key Risks
