Donald Phillips

Measuring success in high yield

Donald Phillips

As we launched the Liontrust GF High Yield Bond Fund last summer, we wrote about the usefulness, or otherwise, of comparing the performance of actively managed funds in this asset class against benchmarks. With our Fund celebrating its first-year anniversary on 8 June, it is an opportune time to review how investors can usefully measure the success of high yield bond funds.

It is typical for the performance of funds to be compared against benchmarks. For high yield bond funds, the benefits of doing so against a traditional broad market high yield index is limited from an investment perspective, however. This is because of the composition of indices and the natural state of their turnover.

We will be using the ICE Bank of America Merrill Lynch Global High Yield index as a comparator for the Liontrust GF High Yield Bond Fund, but it is with the above limitation in mind.

What else can investors use to measure success? How about a mainstream global high yield ETF? Although high yield ETFs are marketed as being good at matching index returns, the reality is quite different. ETF managers effectively cherry pick their index to avoid some of the problems that make generating index-like returns in this asset class so difficult. These include the high cost of trading to match the turnover of the indices; the index basically has frictionless trading, ETFs do not.

Recognising these challenges for passive high yield strategies, as well as their ongoing popularity, we set ourselves the challenge of comparing the performance of our Fund against the iShares Global High Yield ETF over the long term, net of fees.

As active managers, we run a relatively concentrated portfolio compared to peers and happily choose to have little or no holdings in particular sectors. Good credit work, combined with running a relatively concentrated portfolio, feeds into long investment holding periods, reducing the high trading costs typically associated with high yield debt.

How are we doing after a year of managing the Fund? Notably, the average manager in the IA High Yield peer group (of sterling-denominated funds) has matched the ETF (hedged into sterling) since the launch of our Fund with a 3.3% return. As predicted, the tracker has failed to keep pace with the relevant index, ICE Bank of America Merrill Lynch Global High Yield (again, hedged into sterling), which returned 4.4%. Liontrust GF High Yield, meanwhile, has outperformed both, with a 4.7% return on the sterling-hedged share class (Source for all data: Financial Express, 08.06.18 to 07.06.19, C5 share class, total return, net of fees and interest reinvested).

How have we achieved this?

  • First, we typically invest in liquid, standard-size bond issues from developed market companies and have a quality bias driven by our preference for companies with features such as a sustainable competitive edge, access to capital and management and owners with motivations that chime with the interests of bondholders.

     

  • Second, we have a truly active, concentrated approach that primarily seeks to add value through idiosyncratic risk, while attempting to add a little more to returns from fund shape through the cycle.

We have an unashamed preference for public market-listed businesses: only around 22% of the Fund’s holdings are private companies, and if we take into consideration the three independent operating subsidiaries of the listed Liberty Global group, that number falls to 15%. I tend to get a little grumpy reading the regular (misplaced) media output criticising the quality of high yield as an asset class: the average market capitalisation of the listed businesses that make up the vast majority of our Fund is $24bn, in line with the average cap of the FTSE 100. No junk here, thank you.

The corollary of this is that we tend to have very few bonds in the lower-rated part of the market and CCCs have only been 2-3% of the Fund. Over the last 12 months, better quality rated bonds have outperformed the weaker parts of the market; this is not down to a spike in defaults, rather that the market has seemingly shared our preference for such better quality credit.

Our process encourages us to take risk off the table when valuations get stretched and increase it when we deem valuations to be favourable, and this is exactly what we did around the turn of the year. The risk positions we added in December and January have largely been sold at a profit and we see the portfolio today as fairly conservatively positioned. To be clear, the risk we added was consistent with our quality-biased approach rather than buying weak, beaten-up credit. This management of ‘market beta’ has also contributed to the performance of the Fund in its first 12 months.

Meanwhile, our process also eschews accumulations of thematic risk and an anecdote from a recent meeting with a buyer of high yield funds will help to explain why. We were given the observation that a European high yield fund is preferable to a global offering as the former can avoid the risk of the energy sector, which is a big part of the US market.

This was a perfectly reasonable observation from a fund buyer with experience of meeting global high yield managers who run portfolios focused on index relative risk rather than absolute risk – but importantly, it is not a fair observation of our investment process. We seek idiosyncratic risks to keep default correlation among our concentrated number of holdings low. This helps us make good investment decisions when sentiment in the market and, typically, thematic sectors, is weak.

In the fourth quarter of last year, when energy-related bonds were under pressure, we doubled our exposure to the sector (to two holdings), for example, by buying Neptune Energy. This is a high-quality UK North Sea operator, with primarily gas production, led by Sam Laidlaw, former chief executive of Centrica. Overall however, sectors like energy, banking and mining (anything thematic) remain a low proportion of the Fund.

Of course, as high yield managers, we have taken a couple of bumps and scrapes along the way. We had a holding that effectively defaulted, an outcome we would deem to be sporadic rather than regular given our quality bias. Wind turbine manufacturer Senvion, in the space of a few months, went from raising equity to help finance its substantial growth pipeline to project execution issues that quickly led to a significant liquidity squeeze. Its demise was rapid but our position size was small enough for this to be a source of frustration rather than de-railing a good debut year for the Fund.

When we launched the Fund on 8 June 2018, the yield on the market (and Fund) was broadly similar to that of today – in the region of 6% in US dollar terms. As we have written in the past, we believe high yield is a ‘buy’ when yields are in the 7% and higher range but take the view that, overall, there is not really a bad time to own the asset class.

Imagine an investor buying the high yield market at the end of June 2008, with the world facing the spectre of the global financial crisis. The investment would have been broadly even within 12 months (and 23 days for those keeping exact score), which is a far greater display of resilience than the property I bought around the same time.

Heading into the Fund’s second year, we would reiterate our core view on high yield: namely that this asset class deserves a place in a long-term portfolio based on the yield cushion to mitigate defaults and its income-generating and value-replenishing characteristics.

 

Based on our general view that risk assets will see greater volatility in the coming years, it has made sense to keep some ‘dry powder’ and we reduced risk on the portfolio when valuations got stretched in spring after the strong rally. More recently however, we have seen modest volatility return and are preparing to increase risk again when our valuation targets are met.

 

Discrete performance*

 

 

08.06.18-07.06.19

Liontrust GF High Yield Fund C5 Acc (GBP hedged)

4.70%

iShares Global High Yield Corporate Bond ETF (GBP hedged)

3.30%

ICE Bank of America Merrill Lynch Global High Yield (GBP hedged)

4.40%

 

Discrete data is not available for five full 12-month periods due to the launch date of the portfolio.

* Financial Express, 08.06.18 to 07.06.19, C5 share class, total return, net of fees and interest reinvested. The primary share class for this Fund is in US dollars (B5) but we are showing the C5 sterling-hedged class to compare against the iShares ETF, on which the sterling-hedged shares are the only fully hedged class available.

The 5 share class was selected as the primary as it is the lowest-charging freely available for sale through third-party platforms.

For a comprehensive list of common financial words and terms, see our glossary here.


Key Risks 

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 and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. 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 and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided 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. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, June 11, 2019, 11:25 AM