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Donald Phillips
Donald Phillips 30-04-21

Should you still invest in high yield when credit spreads are low?

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise.

The high yield bond market has experienced a substantial move from near historic ‘wides’ in ‘credit spreads’ (i.e. high yields compared with government bonds) to near historic lows (i.e. low yields). Given that we commented a lot last year on the benefits of investing in this asset class when yields are high, does this mean we think the market is a sell now yields are at historic lows? The answer is no and we will explain why...

Borrowing analysis from Jefferies, since 2000, there have been 12 occasions when the European high yield index spread has dropped (meaningfully) below 3.5%. What’s interesting, and perhaps counter to the mood around high yield, is the index generally went on to register positive total returns over the next three, six and 12 months. The two exceptions were going into the 2008 financial crisis and going into last year’s lockdown. Excluding these two big events, the average returns were substantially higher, as shown in the table:

The reason that high yield returns are so solid despite the ‘expensive’ entry point in terms of credit spread is that the income component of returns is more significant. As shown in the chart below, borrowed from ourWhy high yield bonds are an evergreen asset” article last month, the price component of high yield bond returns is subordinate to income and is often actually negative due to the impact of defaults.

Any price gains from investing at a wide credit spread and benefiting from tightening is a bonus on top of the main event, which is the coupon income. Likewise, investing at tight credit spreads may result in some negative price performance if they subsequently widen, but this should be outweighed by coupon income if the bonds are held for any reasonable length of time.

As the chart below shows, positive returns have also been likely even when investing at below a 300bps credit spread. Since 2000, there have been only nine occasions when the index spread fell below 3%. The subsequent returns were generally still positive, and especially so when excluding the Covid-related drawdown. Only for a three-month holding period would you have incurred negative performance, with returns improving the longer the bonds were held.

This analysis needs to be framed against what clients can expect to earn from other asset classes. For example, government bond yields are low or negative, investment grade not much better and cash does nothing in the bank.

There has been an understandable transition to equities so far in 2021. Yet like bonds, the valuation of growth stocks have been more than a little inflated by low interest rates. Value stocks may be enticing, but often come with exposure to commodity-cyclical sectors.

We believe the Liontrust GF High Yield Bond Fund can generate 4-5% returns in the next 12 months, in-line with the historic average from a low spread starting point shown by Jefferies’ work. Our Fund is very light in commodity cyclicals and with a bias towards the higher quality parts of the high yield market.

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Key Risks 
 
Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.
 
Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies which may have the effect of increasing volatility. Some of the Funds may invest in derivatives. The use of derivatives may create leverage or gearing. A relatively small movement in the value of a derivative's underlying investment may have a larger impact, positive or negative, on the value of a fund than if the underlying investment was held instead.

 

Disclaimer
 
This is a marketing communication. Before making an investment, you should read the relevant Prospectus and the Key Investor Information Document (KIID), which provide full product details including investment charges and risks. These documents can be obtained, free of charge, from www.liontrust.co.uk or direct from Liontrust. Always research your own investments. If you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances. 
 
This should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust. Always research your own investments and if you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances. 
Donald Phillips
Donald Phillips
Donald Phillips joined Liontrust in February 2018 from Baillie Gifford to co-create the Liontrust Global Fixed Income team. Donald had been co-managing the European high-yield strategy at Baillie Gifford since 2010 and previously worked at Kames Capital from 2005 to 2008.

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