Bond’s not back just yet – but bonds are. We might not know who will play the next 007 but we do know investors are returning to fixed income assets. Over October, our research coverage had a high-yield focus although, with credit spreads still very tight, the relative yield attractions of government bonds have been at the heart of our recent conversations with fund managers.
At the time of writing – an important caveat given how quickly markets are moving – UK gilt yields are consolidating around multi-year highs, with the 10-year gilt offering a tasty yield of nearly 5.4%. Meanwhile, US treasury yields reached their highs in early October and have since fallen as buyers swept in from the sidelines – particularly those seeking a lower-risk play as the AI and technology trade took a pounding.
While there are valid reasons to question the current investment case for government bonds, recent price action reminds us there are times when they play a key defensive role within a portfolio – and you do not always know when that moment will come. Right now, the bonus of an attractive real yield only adds to their appeal.
‘The yield is not enough’?
On the credit side, while relatively juicy ‘all-in’ yields continue to draw investors in, a material proportion of these yields can be explained by the nominal yield. This has led many managers to migrate up the quality curve as they consider whether a sliver of additional return is worth the extra credit risk.
It also means that high yield bonds have become increasingly sensitive to interest-rate risk. This has not necessarily been an unwanted factor for managers, who have sought to take some advantage of the relative value offered by government bonds.
Equally, there have continued to be strong arguments in support of credit: corporate balance sheets have been broadly healthy; earnings have been stronger than expected; and the default rate has remained low. In aggregate, the high yield market is of higher quality because more questionable borrowers have increasingly sought finance through the leveraged loan and private credit markets.
“Many in the investment grade space have bought the hyperscalers’ debt – but there is a limit to how much of the issuance can be digested and widening spreads reflect that reality.
While equity managers need to focus on finding the AI winners in a race no-one fully understands, bond managers can concentrate on avoiding the losers and steering their investments towards opportunities that offer greater cashflow certainty.”
The extent to which AI investment has contributed to global economic growth has been a common topic of conversation, leading to the next question: what happens if and when this investment falters?
Against this nuanced backdrop, the shift to higher-quality names within high yield funds has been gradual rather than wholesale – but the mood is pretty clear: this is no time to be a hero. Mike Scott of Man High Yield Opportunities talked to us about moving up the capital stack, focusing on first lien and secured investments and expressing a preference for businesses backed by hard assets.
For his part, Faisal Islam of Baillie Gifford High Yield Bond favours high-quality B-rated names, where there is an additional yield cushion compared to relatively pricey and crowded BB names, but he is treading carefully in the knowledge that securities can quickly become stressed.
‘No time to AI’?
There is disquiet from some quarters about the growing presence of AI-related names in the high-yield market. As in equity markets, opinions about the scale of capital spending are somewhat divided – but billowing leverage, rapid product depreciation/redundancy, intra-company circularity and off-balance sheet activities are just some of the primary concerns. Many in the investment grade space have bought the hyperscalers’ debt – but there is a limit to how much of the issuance can be digested and widening spreads reflect that reality.
Episodes of massive capex rarely end well and bond investors have not forgotten the painful aftermath of the debt-fuelled telecommunications and shale buildouts earlier this century. While equity managers need to focus on finding the winners in a race no-one fully understands, bond managers can concentrate on avoiding the losers and steering their investments towards opportunities that offer greater cashflow certainty.
Thinking about ways in which to shield his fund from AI volatility, Daniel Pearson of Schroder High Yield Opportunities has been looking at names such as footwear brand Skechers, where the BB secured bond offers a yield to maturity (in sterling terms) in the region of 7.25%. Much like the shoes, perhaps, that is not to be sniffed at.
‘Quantum of solace’?
That said, high yield managers are always on the look-out for bargains and, as John Ryan of L&G Active Global High Yield Bond pointed out, with price dispersion on the rise, opportunities come knocking as the gaps between the winners and the losers widen.
Some managers are more prepared than others to get involved in more troubled, idiosyncratic situations. With a steady head, strong credit work and a willingness to take on risk when the metrics are stacked in your favour, these can be good money-making moments for active managers.
Like others, Thomas Moore of Invesco High Yield is prepared to devote a small portion of his portfolio to companies in tricky spots, undertaking time-consuming work to identify those with a path to financial resolution and therefore the potential to offer good returns. Experience, strong analytical skills and access to legal resources are of huge importance when conducting analysis on these bonds.
Our preference is always to deploy actively managed funds for exposure to corporate and high yield bonds. This is never more so than in choppier credit waters, where avoiding deteriorating names is critical, as is having the flexibility to take advantage of episodes of volatility, steer clear of expensive issuers and dig more deeply into areas of greater stress in the pursuit of potentially larger rewards. These are luxuries that are not afforded to passively managed funds.
Gill Hutchison is managing director – research at Fund Research Centre
