Prospects for high-yield bonds

What is the outlook for the high-yield bond market?

In many ways, the factors that are driving the outlook for the UK economy as a whole are also acutely important for the performance of the high-yield bond market.  

For high-yield bonds to thrive, economic conditions tend to need to involve high and rising inflation, and a positive economic growth outlook.

The former is important as it increases the relative attractiveness of the income from the bond, when compared with cash or government bonds, which are traditionally viewed as lower risk, but which offer lower yields as a consequence.

The latter is important as economic growth would be expected to increase the likelihood that the companies that borrow the money will be able to pay the interest and coupon on the debt.

Thus it could be said the ideal conditions for high yield to thrive actually occurred in 2021 and in the opening months of 2022, as investors adjusted their expectations for how high inflation could go, but also were generally optimistic around the outlook for GDP growth.

As 2022 rumbles on, the inflation part of the narrative has come through, but growth expectations globally have been revised downwards.  

The Bank of England has, in its latest forecasts, anticipated a sharp deceleration in the level and pace of economic growth in the UK over the coming 12 months, while at the same time predicting that inflation could peak at more than 10 per cent this year. 

The challenge facing investors is that the former outcome would typically encourage investors to buy lower risk assets such as government bonds, but the value of the income from those is severely challenged by higher inflation.

Those who buy the high-yield assets as a mitigant against inflation face the challenge that recession could lead to more companies defaulting on their debt, and investors in that debt losing money. 

Colm D’Rosario, co-head of emerging market and high-yield corporate debt at Amundi, says: "At the start of the year, I think most people were quite constructive in terms of their outlook for the global economy, and expected growth to continue and rate rises to happen.

"But the Ukraine war and the lockdowns in China have changed that; policymakers are now having to walk a tightrope, trying to combat inflation without completely killing off growth."

But he says that while the macro outlook is not, on the surface, positive for high-yield bonds, there are circumstances which may mean the picture is less onerous for investors in the asset class than first appears to be the case. 

He says the pandemic caused companies to reduce debt levels, while the positive economic growth conditions of 2021 meant corporate earnings were strong, enabling businesses to build up cash balances in advance of any economic storm.

This is atypical of many economic cycles as recessions more frequently occur after periods of what Alan Greenspan, a former US Federal Reserve chairman, called “irrational exuberance”, as businesses respond to the period of strong economic growth by borrowing more, and leave themselves much less prepared for any subsequent downturn, as happened during the global financial crisis. 

D’Rosario is not completely bullish on the outlook for his asset class though, as he says high-yield bond prices are not currently pricing in a recession, and as a recession is a possible outcome this reduces the relative attractiveness of high-yield bonds.

Rhys Davies, bond fund manager at Invesco, says he came into this year being quite cautious on the outlook for high yield because the positive economic outlook of 2021 led to the price of high-yield bonds rising sharply, but with growth always expected to slow down this year, even without the Ukraine conflict, he felt the higher prices, while they may have justified the conditions of 2021, were wrong for the likely conditions of 2022. 

He adds: “In 2020 high-yield bond prices made a strong recovery and 2021 was a very stable year, but we knew from the signals being sent by central banks that 2022 would see a change of market conditions.” 

But he says the slightly worse performance of the first part of this year means that prices have fallen and “yields are now starting to look very attractive, certainly at the higher quality end of the high-yield market”.

Chris Higham, a senior portfolio manager in the fixed income team at Aviva Investors, says he will remain underweight high-yield bonds relative to the rest of the market until the interest rate hikes, currently much discussed, actually happen, as he wants to see the impact of those changes on the prices of bonds before potentially increasing his investments. 

He says the recently announced rate rises in the US and UK are just “the starting gun” on a rate rising cycle. 

Sophie Burke-Murphy, investment director at discretionary fund manager Featherstone, says: "While high-yield bonds have historically performed quite well in a rising rate environment, we don’t see them as a particularly attractive asset class right now.

"Central banks have a very difficult balancing act ahead of them, trying to keep inflation under control by raising rates without sending global economies into recession.

"The risk of policy error is high and if global growth does slow down significantly high-yield bonds are not going to be a comfortable place to hide.”

QT or not QT? 

One of the major drivers of bond market performance over the past decade has been the policy of central banks of buying bonds as part of quantitative easing, with the aim of driving bond yields down, to keep interest rates low and stimulate economic activity. 

But after more than a decade of that policy, central banks are now preparing for quantitative tightening, which involves selling bonds they have bought back into the market.

In effect, central banks are moving from being buyers of bonds at almost any price to sellers of bonds at almost any price, just at the time when higher inflation may be dampening demand for bonds. 

Although only a relatively small segment of the bond holdings of central banks will actually be high-yield bonds, the impact on that part of the market could be akin to the impact a stone has as it ripples through water. 

So when government bonds are sold, this causes the price of those assets to fall, pushing the yield upwards. 

Because the yields on lower risk bonds are rising, this makes the higher yields of the riskier bonds less attractive.  

Higham says that because high-yield bonds in European markets were “a big beneficiary” of QE, it is intuitive that a reversal of that policy would lead to high-yield bonds struggling. 

But Davies takes the view that the market always knew that QT was coming and has over recent years adjusted to this, meaning the impact of any future shock will be greatly diminished. 

Joseph Lind, senior portfolio manager at Neuberger Berman, says the QT issue is most likely to have an impact on the “lower quality” end of high yield, which he classifies as bonds with a credit rating of CCC or below.

Jon Mawby, bond fund manager at Pictet Asset Management, says: “The unwinding of QE means it's harder to look at any part of the bond market in the normal way.

"Some of the areas of the bond market which are supposed to be safer havens have suffered this year, but investors are starting to focus on being shorter duration, which usually helps high-yield bonds." 

He says volatility may stay high for an extended period, but he finds the top end of the high-yield bond market to have attractive valuations.  

The highest credit rating a bond within the high yield universe can have is BB.             

Quality control   

There are competing theories as to the level, in aggregate, of quality of the investments on offer in the high-yield bond market right now. 

One theory advocated by Davies at Invesco, among others, is that QE and low interest rates enabled many unviable companies to finance themselves in the high-yield bond market, meaning there are collectively more poor-quality bonds in the market now than historically.

The counter view, shared to some extent by Higham, is that the two years of the Covid-19 pandemic flushed out the poorest companies, and enabled the stronger to build up their credit-worthiness. 

Lind describes the concept of companies that are unviable being able to survive as “zombie credit”, but says it is largely at the lower end of the high-yield market that such businesses exist, while in the market as a whole, the area where historically defaults have been highest have tended to be in the oil and gas and natural resource sectors.

Mawby says: “If you remember, Gordon Brown once said he had abolished ‘boom and bust’ and conquered the business cycle. He got pilloried for it, but I have some sympathy with his view. Counter cyclical monetary policy has effectively abolished those cycles and replaced them with more volatility.

“It has created a lot of zombie companies, but created a massive debt pile. The credit quality has probably has gone down, and if monetary policy does normalise, they are going to hike into the worst recession since the global financial crisis. That is why we favour the higher quality end of the market.”

Mawby says he is of the view that higher interest rates and other policies will soon see the rate of inflation and economic growth decline, and as a result “is starting to think about” buying longer duration assets, which would be typically viewed as the opposite end of the bond market to where high-yield bonds are. 

Flavio Carpenzano, fixed income director at Capital Group, says that despite the economic sensitivity of high-yield bonds, they have performed strongly this year because their short duration to maturity, as investors were more focused on inflation worries than growth worries. 

But adds he does not believe that growing fears around recession will have a profound impact on high-yield bonds, as the chances of recession in the US are, in his view, quite low, and the high-yield bond market has got more quality in it now than in the past. 

Lind says such businesses now make up a smaller part of the high-yield market than ever before, arguably increasing its quality, while the present very high levels of commodity prices mean oil and gas companies are more likely to be able to generate the cash to pay their debts.

High-yield bonds are traditionally more correlated with equities than any other part of the fixed income market, but with the historic inverse correlations between bonds and equities having broken down, investors may not view this in the negative light as in the past. 

david.thorpe@ft.com