What Next for High Yield Bonds?

Emma Wall: Hello, and welcome to this 'Investing for Income Special.' I am Emma Wall and here with me today is James Tomlins, Manager of the M&G High Yield Corporate Bond Fund.

Hello, James.

James Tomlins: Hello.

Wall: So, I suppose the biggest question on everybody's lips is high yield really in a bubble?

Tomlins: It's a very good question. I think Janet Yellen has been trying to present that view to the markets and there has been some impacts from that. We've definitely seen some weakness in the U.S. high yield markets, and a lot of outflows from that area. But I think fundamentally, you got to ask yourself a question when you are a high yield investor, do I get paid for the risk I am being asked to take on by the companies who are issuing these instruments to us?

I think there are two main risks that we focus on; and that's default risk, so are these credits paying us additional spreads – credit spread and income to compensate us for perceived defaults; and the other risk is interest rate risk. I think Janet Yellen quite rightly points out that the low rate environment prompts people to reach for yield and to reach for income, and that certainly had an impasse in terms of the technicals and the standard of lending we're seeing in the capital markets. So, I agree with her to that perspective. But I still think, we're actually being compensated adequately for the default risk out there. So in that sense, I don't think we're in a bubble.

However, when we look at interest rate risk, there is definitely the sense that we're at crossroads here. There is many Central Banks, particularly the Fed, and particularly the Bank of England, who are both flagging the facts that the interest rate cycle is turning.

Can high yield survive a bearish outlook for the government bond markets? Well, yes, it can, if the adjustment is slow and gradual and well-paced, if it is a very quick and disorderly adjustment then high yield markets will also have to reprice to reflect that reality. Right now, we think it's going to be fairly orderly and fairly well-flagged process. I think Carney in the U.K. and Yellen in the U.S. are very, very keen on not surprising the markets. They know the volatility impact will be huge.

Wall: I mean, you've mentioned, a quite a lot of the macro influence on developed markets there talking about how Central Banks are controlling interest rates. I know within the fund, you have started to cover a more global outlook. Is that a reflection of the situation in developed markets? And where are you seeing those opportunities on a more global basis?

Tomlins: On a more global basis, when we look at the two big markets for high yield is really the U.S. and the Europe. There is an element of emerging markets in there as well, but in terms of size and market cap, it's very much driven by what's happened in U.S. and what's happened in Europe. And for that reason interest rates and macro outlook is very important too.

I mean, you can buy a bond in the U.S. that optically yields a lot more than a bond in Europe, but that bond in U.S. will have a lot more interest rate risk than the one in Europe. So, you can have an issuer that issues, let's say, a B rated security up, say, 6% over for a five year term. Spread wise in Europe, that's actually almost 500 [basis points] plus in terms of credit spread that you're getting there. The same bond in the U.S. will have a much tighter spread with a similar yield because of the interest rate risk.

So, we do always have this playoff, when we look at the market globally. Do we go for a higher yield in the U.S. now but take more interest risk or do we go for a lower yield in Europe, but feel a lot safer about interest rate risk and take a little bit more credit spread. The emerging markets element as well is also on the agenda.

We see some opportunities here and there. I think it's fair to say, Latin American opportunities look fairly good; Russian and Eastern European opportunities less attractive given the obvious geopolitical risks right now; and also China, there is some definite tensions there in the Chinese high yield market, where we're much more uncomfortable taking risk or we're not being paid to take the risk there at the moment.

So, when you put all that together, we think that U.S. is interesting from yield perspective, but you have to manage your interest rate risk. We think Europe is good from a spread perspective, but you may not get great total returns because of what rates have done and where the government bond markets are trading, and I think emerging markets is very much pick and choose where you want to be exposed from both macro point of view, but also the geopolitical point of view.

Wall: James, thank you very much.

Tomlins: No problem.

Wall: This is Emma Wall for Morningstar. Thank you for watching.