Donald Phillips

What does the government bond rally mean for high yield?

Donald Phillips

We are regularly asked how we are managing duration, or sensitivity to interest rates, in our global GF High Yield Fund. After a major rates market rally, it feels like an opportune time to put pen to paper on this topic.

Period of falling Treasury yields

Treasury yield move
%

US HY returns during period

HY yield
at end of period

HY
spread at end of period

Spread as % of
yield

HY returns over next 12 months

HY return over next three years

5 April to 7 Oct 2010

-40%

8.10%

6.5%

5.3%

82%

-0.6%

27%

8 Feb 2011 to 22 Sep 2011

-54%

-1.50%

8.0%

7.1%

89%

16.6%

33%

19 Mar 2012 to 24 July 2012

-41%

3.20%

6.0%

5.4%

90%

10%

21.4%

27 Dec 2013 to 30 Jan 2015

-45%

6.20%

5.4%

4.2%

78%

-1.67%

19%

10 Jun 2015 to 8 July 2016

-45%

5.20%

5.5%

4.6%

84%

9.4%

21.2%

7 Nov 2018 to date (13.08.19)

-49%

8.50%

5.0%

3.4%

68%

n/a

n/a

Source: Bloomberg. Return data is the ICE BAML Global High Yield Index (ex-energy and CCC debt)

First, some context. History is never a guide to the future and high yield as an asset class does not have a long track record. So with the usual caveats in mind, the above data from the last decade of Treasury market rallies may be of some use in thinking about potential returns from the high yield market.

In the last decade, we have identified six discrete periods of strong Treasury market rallies (defined as a 25%-plus rise in yield terms on the 10-year bond).

Excluding the current episode, there have been three periods followed by strong one and three-year returns after a rates rally and two with anaemic returns over one year but stronger performance over three. The periods with the strongest returns have tended to be when high yield performed poorly during the rates rally. This was typically related to economic growth fears, which should impact defaults, for which lower rates provides some medicine.

What marks this recent bout of strong government bond returns is the extent to which high yield has taken part in the rally. Within this, the strongest part of the market has been the higher-quality areas, which can be more rates sensitive, and where, arguably, more rate-sensitive investors have been focusing to pick up a bit of carry while central bankers underpin the market.

If we assume we are towards the end of the current rates rally (which may well not be the case), what the current period shares with the weaker return years is a lower yield and a lower spread as a percentage of yield. Therefore, from our small sample set, this is not a strong short-term signal for our asset class.

In a portfolio context, we are managing some of the risks posed by the current dynamic by decreasing duration and avoiding the temptation to move into weaker parts of the market that have underperformed (such as thematic cyclicals and CCCs).

For example, it can be seen from the following chart how the Fund duration has progressed since launch. Moreover, we have one CCC holding in the Fund. In effect, we have reduced risk as 2019 has progressed, through owning a higher proportion of shorter maturity bonds and increasing the short position we have in interest rate futures, which will profit if government bond yields increase.

Key duration figures on GF High Yield Fund since launch 

Source: Liontrust, to end July 2019

We have written before that we do not believe clients should overly fret about their timing into the high yield market. Even buying high yield in June 2008 proved to be a perfectly reasonable investment within a year or two: the income-generating, yield-replenishing characteristics of the asset class bake in this resilience.

Today, we offer prospective clients a high yield fund with an average BB credit rating, an average market cap of around $18bn (of the around 85% of the Fund holdings that are listed) and a relatively low sensitivity to rising bond yields, with an aim to outperform market and passive fund returns over the medium to long term.

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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.

Wednesday, August 28, 2019, 10:17 AM