Income opportunities in the high yield bond market - Global bonds and currencies

High yield income as an alternative to equity income

A strong case has been made over the last year that in this period of low growth, investors should focus on equity income strategies.Alongside the rationale for this case, at Newton we believe that high yield bonds may provide an attractive alternative for investors. Exhibit 1 shows the cumulative returns of the US high yield market* as compared to the FTSE 100, S&P 500 and S&P 500 Dividend Aristocrats indices** on a total return basis from October 2001 to the end of October 2011. The returns over this period of the FTSE 100 and S&P 500, at around 61% and 47% respectively, are well below the S&P 500 Dividend Aristocrats index return of around 108%. However, the US high yield index has achieved the highest cumulative return of 141%, with an annualised return of 9.1%.

When assessing the attractiveness of an asset class, return should not be the sole element of consideration: volatility also needs to be taken into account. As Exhibit 2 illustrates, high yield bonds have exhibited a lower level of volatility than the equity market indices assessed. Throughout most of the last decade, the volatility of high-yield bonds has been lower than that of the main developed-market equity indices. In late 2008, high-yield volatility increased to match that of equity indices, as the corporate bond market suffered severe dislocation following the effects of the Lehman Brothers' bankruptcy. However, since mid-2009, that volatility among high-yield bond markets has reduced significantly, and over the last couple of years has returned back to a level below that of equity indices.

Exhibits 1 and 2 demonstrate that, on a risk-adjusted basis, high-yield bonds have provided a higher return over the last 10 years than the main developed market equity indices. High-yield bonds comprise further attractive features, such as the fact that payment of coupons is a contractual obligation, rather than a discretionary decision and, at maturity, investors must be repaid at par. The biggest worry for high yield investors is defaults and restructurings, which may result in coupons being unpaid and investors being asked to take a 'haircut' on their principal investments (i.e. accept a lower payment at maturity than the amount originally invested). However, we believe the outlook for high yield corporate bonds remains positive.

Default rates

The default rate environment in the high yield market for the next 12-18 months looks very benign: Moody's expects a rate of around 2% for the next 12 months. The key reasons behind this low default expectation are good progress in refinancing and strong corporate balance sheets.

As demonstrated by the charts in Exhibit 3, over the last couple of years, the majority (around 70%) of issuers use the proceeds of new debt issues for refinancing and not for general corporate purposes or acquisitions. Leverage continues to be on a downward trend as managements increase their focus on improving creditworthiness. Both of these elements are positive for credit, as they help to maintain sound balance sheets.

High yield performance in a low growth world

The "sweet spot" for high yield is real economic growth in the range of 1-2%. Above 2%, economic expansion usually leads to an increase in underlying government yields and is usually inflationary; both of these factors start to erode the credit spread available on the asset class. Furthermore, in such an environment, there is usually an asset allocation shift away from high yield into equities, which is clearly unfavourable for the asset class. On the other hand, sustained real economic growth of below 1% will usually result in an improvement in default rates, which is negative for the asset class. A level of 1-2% real economic growth is the optimum range, as the income from the asset class is attractive and growth is not low enough to spur an increase in default rates. Moreover, such low-growth periods tend to result in significant volatility in markets, which discourages leveraged buy-outs and heavy capital expenditure, and forces managements to maintain stronger balance sheets. Also, such an environment forces investment-grade companies to pursue growth through acquisitions, an activity from which high yield corporate bonds tend to benefit. In a low-growth environment, the focus should be on companies which are cash generative, have a robust asset base and do not require top-line growth to be able to grow into their capital structure. In conclusion, even if high-yield credit spreads do not contract in this environment, we believe the income is attractive enough to justify remaining invested.