Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Tom Becket, chief investment officer of Psigma, gives his outlook for high yield bonds.
The best risk-adjusted asset allocation call you could have made in the depths of the financial crisis of 2008 was to go long corporate credit and simply hold it for the last seven years. Of course there have been bumps and bruises, such as late last year, and there were times to be region or sector specific, but broadly it has been a remarkably rewarding time for investors in the asset class. It is unlikely to ever be repeated in our careers.
The problem with 'high yield' credit is the yield is not very high
Having discussed bond yields and the dangers of heavily-correlated – to Treasuries – investment grade credit many times in the last few months, I wanted to spend some time today evaluating the outlook for high yield credit that I have formed in my three weeks in the US, the original home of the 'junk' bond.
Let's start by giving credit where credit is due. The moniker 'junk' that was first ascribed in the days of American financier Michael Milken and his devilishly ingenious pals in the late Eighties is now mostly antiquated. Yes, as with every asset class, there is some trash to be avoided, but high yield bonds have grown up and the asset class is far higher quality than it was in previous decades.
Now seen as an institutional-friendly asset class, to sit alongside sovereign debt and investment grade bonds, the types of companies one can lend to are generally of a better vintage than at various points of previous investment cycles. This has been reflected in extremely low default rates over the past few years and can be evidenced in the mostly sensible uses of the cash that companies have raised in bond markets.
The obvious problem with 'high yield' credit is the yield is just not very high. The US index offers you a yield of about 6%, markedly lower than what you could have achieved most of the time in history. But we are keen advocates of the important rule in investing that the 'past is the past, the past is not prologue', so the reality of rock bottom interest rates, laughably low government bond yields, low inflation and low growth volatility means that one has to reassess whether this 6% is good value.
As much as I want to say otherwise, being a contrarian at heart, I come back from the US with the belief that if you are invested with good managers and you are comfortable with the fund structure then high yield credit still offers a perfectly respectable outcome in most scenarios.
It is currently hard to judge what the scenarios are that could materially damage the prospects for high yield. Maybe we should be concerned that the outlook is seemingly so relaxed. The clearest present danger comes from the actions of the Fed later this year. In her latest of a never-ending series of comments last week, Fed Chair Janet Yellen suggested that a September rate rise was likely, but the path of rates higher would be shallow and slow.
However, if that likely scenario was to change for whatever reason then the lower yields and now-tighter spreads over government bonds on offer in high yield would undoubtedly be subject to intense upward pressure.
The other constant threat for high yield bonds is defaults. Many of the questions I bored the managers at the meetings I attended centred on where they thought we were in the 'leverage cycle' and whether they thought that we were starting to see signs of excess. Again, managers I met with were mostly relaxed.
Clearly companies are not as conservative as they were when the wounds of the GFC were first healing, but despite an obvious application of raised funds to M&A, we are not looking at generally 'flash with the cash' US corporate boardrooms. Defaults might rise as the severe falls in energy and commodity prices start to bite those sectors, but elsewhere it is hard to currently see a surge in companies failing to pay their dues, not least as companies have been smart in extending their loans a long way in to the future.
So my conclusion is perhaps even more yawn-inducing than many I have come to in the past, but it appears that the outlook for US high yield is perfectly sensible. Yes, yields are lower, but I expect the outcome to be ultimately steady and sound. In a world where it is increasingly hard to find 'value' investments it makes sense to persist with our now long-held overweight in US high yield.
Given the expensive nature of many US equity valuations there is a good chance that credit will outperform equities in the years ahead, especially as demand for income across the yield-strapped world continues.
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