After a painful adjustment to higher interest rates in 2022, there are whispers that bonds may be back. Yields are at decade-highs, inflationary pressures appear to have peaked and investor interest is reviving. However, with an uncertain economic outlook, there are still risks to be navigated.
The investment trust sector tends to gravitate to specific parts of the fixed income market. It is a natural home for higher yield bonds or loans, for example, where there is less liquidity. As it happens, this has been the better place to be in 2022: while ‘safe’ government bonds and investment grade credit saw double-digit losses, high yield debt benefited from lower exposure to interest rates and a relatively benign corporate environment. Most trusts were flat on the year.
Even after this relatively robust performance, yields look attractive. The CQS New City High Yield (NCYF) fund is the highest, with a yield of 8.8%[1], but Axiom European Financial Debt, CVS Income & Growth and Invesco Bond Income Plus (BIPS) are all yielding between 6% and 7%. By comparison, a UK 10 year gilt is currently yielding 3.3%[2]. The aggregate yield on US high yield bonds has only been higher twice in the past decade – in February 2016 and at the height of fears over the pandemic in March 2020[3].
However, there are two elements that may give investors pause for thought. A weakening economic climate may bring a rise in the default rate; and further rises in borrowing costs are possible if inflation persists. While high yield bonds are less sensitive to rate rises than government bonds or investment grade corporate bonds, there is still a relationship and it could push yields higher (and prices lower).
Default rates
Default rates have been low for much of the past decade. Highly indebted companies have been kept afloat by low borrowing costs and there is a danger that more companies go bust as interest rates rise and economic conditions deteriorate. In January, the UK government’s insolvency service reported a 30% rise in business insolvencies in 2022, a 13-year high[4].
Rhys Davies, manager of the Invesco Bond Income Plus Trust, says: “We have had an extended period of supressed default rates because of central bank interventions. The whole market has now shifted to higher yields, that means higher borrowing costs for corporates. In the high yield market, these are companies with leveraged balance sheets and they will have to adjust to paying more when they refinance.”
In a recent report, Fitch currently expects 2023 default rates for the US high yield market to move to 2.5-3.5%, ticking up to 3-4% in 2024. While this looks high relative to the near-zero rates experienced over the past decade, it is well below the 22% and 14% default rates seen during the financial crisis.
It added: “European high yield bond default rates will rise materially in 2023 and 2024. We re-affirmed our base-case bond default rate forecast for 2023 at 2.5% and introduced a 2024 projection that assumes defaults rise to 4.0%.”[5]
Nevertheless, Ian Francis, manager of the CQS New City High Yield fund, says that investors are increasingly being paid to take the risk: “For a long time, high yield bonds had a relatively low margin over gilts, but today they are back in my comfort zone.” Davies agrees that there is a lot more yield available, which provides some potential capital upside, and a lot more choice.
Improving credit quality
There are other elements that may limit the impact of higher default rates. For example, the credit quality of the high yield market has improved over time. After the difficulties seen during the credit crisis, when high yield issuers were at the coal face of the rapid withdrawal of liquidity, the high yield universe has become more diverse and mature.
Equally, the ‘maturity wall’ has been extended. Davies says: “A major positive for the bond market at the moment is that a lot of companies in the high yield bond market were able to refinance in 2021, which helped push maturities out.” Many companies don’t need to come back to the market in the short-term. Equally, economic weakness acts as a natural brake on borrowing. Not as many companies want to undertake merger and acquisition activity, for example. The resulting lack of issuance is likely to create a tailwind. “We’re not overplaying it, but health is returning to the market,” he adds.
Stock selection
That said, it is a market that requires judicious stock selection. There will be individual companies that need to roll over their debt and will have to pay far more. Davies says that while issuance was limited in 2022, where companies have had to borrow the rates have been far higher. He gives the example of Swiss security company Verisure, which came to market with a 9.25% bond for five years in 2022. At the start of 2021, it had issued a six-year bond of 3.25%. This increase is good for investors, he says, but companies need to be able to afford these higher interest costs.
Francis is finding opportunities among smaller, less liquid companies. He says: “These are often over-looked by larger investors, but are well run and well-funded and available to managers of closed-ended funds without liquidity constraints. Permanent capital is very helpful in this type of situation. I can look at opportunities that larger funds can’t.”
He has significant exposure to financials, where yields are high and balance sheets healthy. He is also finding some interesting ‘green’ bonds and energy-related names. Smaller names have weaker liquidity in the secondary market, but he plans to hold them to redemption. He is also holding the maximum allowable in equities, to give the fund some inflation protection.
Davies says his approach is “very much bottom-up and credit by credit.” He’s avoiding the higher risk end of the market, even though yields are high. He adds: “Retail has been a tough environment, particularly the high street. We have also been avoiding companies with weaker pricing power. This includes areas such as the auto-supplier sector that may find it difficult to pass on higher raw materials costs.”
A final risk to consider is inflation. While high yield bonds tend to have less exposure to interest rates than other parts of the fixed income market, they are not immune. US high yield bonds trade at around 4% higher than US treasuries. That gives a margin of error, but is not particularly high relative to history. Spreads peaked at almost 11% during the height of the pandemic[6] and were as high as 6% as recently as July. While the inflation outlook is much better, it may still influence pricing.
Are bonds back? There are still risks, but high yields provide a substantial cushion across much of the fixed income market. Equally, the cliff-edge risks on interest rates are no longer as significant. Careful credit selection is necessary in a febrile economic environment, but there are undoubtedly opportunities for the year ahead.
[1] https://www.theaic.co.uk/investment-company-screener#?filtersSelectedValue=%7B%22aICSectorId%22:%7B%22id%22:%22LC00002812%22%7D%7D&page=1&perPage=10&sortField=legalName&sortOrder=asc&universeId=CEWWE$$ALL_5549
[2] https://www.marketwatch.com/investing/bond/tmbmkgb-10y?countrycode=bx
[3] https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY
[4] https://www.theguardian.com/business/2023/jan/31/business-insolvencies-firms-go-bust-2022-england-wales
[5]https://www.fitchratings.com/search/?filter.reportType=Special%20Report&query=High%20Yield%20Default%20Insight%20Report
[6] https://fred.stlouisfed.org/series/BAMLH0A0HYM2