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 our “Why 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.
Key Risks
