Volatility fails to stir bonds

Spreads between the price of high yield bonds and US Treasuries have remained at historically low margins this year despite a degree of volatility. This raises question marks over the value offered by high yield bonds to investors at current prices, especially in the US market.

A number of factors have led to spreads remaining at tight margins. Among these are investors’ willingness to hold higher risk assets, investors seeking extra income from assets, low yields on long-dated government bonds, historically low default rates and what has been seen as a positive economic environment for companies.

Potentially, the situation may be undergoing a change, however. While the economic outlook can always be described as uncertain, there has been increased nervousness that has been partly caused by Hurricane Katrina, the threat of continued high energy prices, the possibility of rising inflation and concerns about the effect of higher interest rates in the US on the housing market. There is continued discussion also about the potential effects of the budget deficits in the US and imbalances in the global economy.

One argument in support of the belief that high yield spreads will remain low is that it is hard to see a reason for long-dated government bond yields to rise. Supporters of this view say there is little sign of inflationary pressures that would prompt the market to expect interest rates to rise significantly in the future. A new chairman of the Federal Reserve and a subsequently looser monetary policy could be one such catalyst.

There is a general view among the managers of the largest cross-border high yield funds that there is relatively little value to be found in the US, which comprises more than 80 per cent of the global market.

Local currency

But it is common for funds in this sector to be able to invest significant proportions of their assets in emerging market bonds and US Treasuries. Many have identified local currency emerging market debt as offering the best investment opportunities in their universe at the moment.

The advantage of holding both high yield bonds and emerging market debt, says Claudia Calich, manager of the Invesco GT Global High Income fund, is that they have “low correlations to each other and their spreads over US Treasuries usually develop differently”. Ms Calich says her fund will typically hold up to 70 per cent in high yield debt. Currently, the fund is split around 50/50 between the two asset classes.

The current 50 per cent holding in high yield debt reflects caution about the value offered by this asset class. “The risk premium of high yield debt over US Treasuries is too low given the economic risks at the moment, such as from rising oil prices.” It could be argued, therefore, the risk is for spreads widening and investors facing the potential of suffering capital losses.

She attributes the low high yield spreads to strong corporate fundamentals as balance sheets have been strengthened in recent years through de-leveraging. High yield debt is generally less sensitive to movements in interest rates than investment grade bonds. But the higher the credit quality of high yield the more sensitive they are to interest rates.

Even though Ms Calich says the risk premium is low, she does not expect spreads to widen significantly or remain much wider. “The most likely scenario is for high yield spreads to remain within a trading range over the next year. Spreads could widen from here but would then be likely to narrow again because of the demand for high yield bonds.”

She attributes the improved performance of the Invesco GT Global High Income fund over the past year to its increased allocation to emerging market debt, which is a strategy pursued by other funds in the sector. According to Standard & Poor’s, the fund returned 10.57 per cent in the 12 months to 12 September 2005 compared to 9.49 per cent by the Lehman Global High Yield fund.

Paul DeNoon, manager of Alliance Capital’s ACMGI Global High Yield, which is the largest cross-border fund in Europe with ?1.95bn in assets, has split the portfolio into three similarly-sized classes. These are US high yield bonds, dollar denominated emerging market debt and local currency emerging market bonds.

Upgrading credit quality

He has been improving the credit quality of high yield debt within the portfolio over the past three to four months. “We have upgraded the credit quality and become more selective generally because of the tight spreads and the continuing rise in the Federal Reserve rate which could make the economic environment more difficult for companies,” says Mr DeNoon.

“We saw the general underperformance of US high yield debt in September and this has reiterated our belief that investors need to focus on individual companies and securities at the moment. We have been avoiding the debt of companies that are vulnerable to high energy prices, such as airlines and auto stocks.”

In conjunction with the improvement in credit quality, Mr DeNoon says he has not been seeking to increase his exposure to US high yield bonds because of the relative lack of value. Indeed, the weighting to US high yield has been as high as 45 per cent in the past compared to the current 33 per cent.

Not only does the fund’s exposure to emerging markets provide diversification and thus reduce risk, says Mr DeNoon, but it can also offer the opportunity to find better value. “The high energy prices have benefited some emerging markets, notably Ecuador, Russia, Venezuela and Mexico. Brazil has benefited from the strong demand from China for agricultural goods and commodities.”

Mr DeNoon says one of the main objectives of the ACMGI Global High Yield fund is to try to generate income. “This is why we have increased our exposure to emerging market debt. There have been large inflows into emerging market debt and it shows no sign of abating.”

He adds that some of the most attractive value is to be found in local currency emerging market debt. “There is a bond in Brazil, denominated in Real, with a maturity of 2016 that has a yield of 15.25 per cent. In contrast, a dollar denominated bond in Brazil with a maturity of 2015 is only offering a yield of 7.25 per cent. This is a premium of around 700 basis points for the local currency bond.”

Mr DeNoon attributes the out-performance of the ACMGI Global High Yield fund against the index over the past year to the increased exposure to local currency emerging markets debt. The fund returned 14.15 per cent in the year to 12 September 2005, well ahead of the benchmark.

Best period of the year

While there is a lot of support among fund managers for emerging market debt, particularly local currency bonds, Daniel Doyle, co-manager of the Henderson HF Global HY Bond fund, says we are approaching the best period of the year for high yield debt. “The high yield tends to do well between November and the second week of January. September and October are not usually great for high yield. This is because of the issuance calendar with most new bonds being released in September and October.”

Even though high yield spreads are at historically low levels, Mr Doyle points out that yields have been volatile this year and are not far from offering fair value to investors again. “We believe high yield bonds offer fair value at spreads of around 400 basis points above US Treasuries whereas they are expensive at between 300 and 350 basis points. In middle March, the JP Morgan High Yield index reached around 300 basis points and then widened to 475 basis points after General Motors was downgraded to junk status by Moody’s. The index has now come back to a spread of 370 basis points over US Treasuries.

“The next six months look like a benign environment but wider spreads would present investors with opportunities. For instance, there has been a net outflow of $8bn (?6.58bn) of retail money from high yield debt this year.”

Focus on the us

Between 75 per cent and 95 per cent of the Henderson HF Global HY Bond fund is invested in US high yield bonds. The rest is split between European high yield and emerging markets debt. But unlike other managers, Mr Doyle says he does not have exposure to local currency emerging market debt and this is why the fund has under-performed many in the sector in the year to 12 September 2005 with a return of 5.98 per cent.

A risk posed by high yield debt is of the default rate rising. This is also at historically low levels of 2.09 per cent on 31 July. Moody’s has estimated the default rate for high yield bonds will rise to 3 per cent during 2006 but Mr Doyle says even at this level it is relatively low.

Marino Valensise, manager of the Baring High Yield Bond fund, says there is a technical reason why there is an expectation that default rates will rise. “There was a significant increase in issuance of lower quality high yield bonds in 2003. This means in 2006 and 2007, it is expected that defaults of CCC bonds will rise. We have a large weighting to BB high yield debt at the moment.”

Mr Valensise says one of his fund’s main aims is to try to pay high dividends to investors and to distribute all the income in the fund. He says this means the fund takes a less aggressive investment approach than other funds in the sector. “The return of the typical high yield fund will vary between -15 per cent and 40 per cent but ours usually moves between -3 per cent and 20 per cent.”

‘There was a significant increase in issuance of lower quality high yield bonds in 2003. This means in 2006 and 2007, it is expected that defaults of CCC bonds will rise. We have a large weighting to BB high yield debt at the moment’ Marino Valensise, Baring High Yield Bond Fund

He argues that the volatility of high yield bond funds can be reduced through allocations not only to emerging markets debt but also to US Treasuries.

Fears are balanced

Robert Burdett, co-manager of the Credit Suisse Portfolio Service, says high yield is likely to continue to remain in its trading range as fears are balanced between the economy moving between inflation and deflation. “We would expect high yield prices to fluctuate in a range for the next six to nine months.

“Given this environment, we have retained our exposure to high yield but we are not adding to our weighting. We have held Thames River High Income in our portfolios for some time. This is a global fund and we can leave the asset allocation to the manager, Michael Mabbutt. It is very difficult for investors to monitor and manage asset allocation within high yield debt.”

‘We saw the underperformance of US high yield debt and this has reiterated our belief that investors need to focus on individual companies’

Paul Denoon, Alliance Capital