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Signs that the high yield bond market is overheating

16 February 2018

Rathbone’s Noelle Cazalis explains what a surge in high yield bonds means for the market and how the team are de-risking its strategic bond fund.

By Maitane Sardon,

Reporter, FE Trustnet

While high yield bonds have delivered attractive returns over the past decade, higher-than-usual issuance at not very attractive valuations could suggest the market is overheating, according to Rathbones’ Noelle Cazalis (pictured).

The manager, who runs the four FE Crown-rated Rathbone Strategic Bond fund with head of fixed income Bryn Jones and head of multi-asset David Coombs, said that the market no longer offers adequate returns for the risk of investing.

While high yield bonds have delivered attractive returns over the past decade, Cazalis said a correction is likely and has begun to de-risk the fund portfolio.

“People have been chasing risk, they have been getting exposure to high yield and getting risk when they maybe didn’t understand what they were doing,” she said.

“We feel valuations have gone a long way and high yield is looking very expensive. We have therefore decided to de-risk our portfolio, which has resulted in a good performance.”

The fund delivered a 6.34 per cent total return last year, compared with a 5.31 per cent gain for the average IA Sterling Strategic Bond sector fund.

Performance of fund vs sector in 2017

 

Source: FE Analytics

Cazalis said the level of high yield issuance at the start of 2018 compared with the amount of higher-rated, safer bonds issued suggested the market was overheating. 

“At the start of this year we saw a lot of high yield deals coming to market,” she explained. “This means very tight spreads and companies that have never issued before or companies we have never heard of, coming and printing.”

Cazalis said valuations in the high yield sector have risen too much as investors have chased yield in the low-rate environment but perhaps taking on more risk than they realise.

She said: “If you look to the iTraxx Xover – that represents high yield risk – you can see the implied default by the market is 16 per cent, which is the same as the average default rate.

“This means you get compensated for an average scenario but if high yield blows out and you see spreads widening, you don’t get compensated.”


Indeed, while investors will be compensated in a more positive economic environment, current default rates show investors are not being compensated when putting their money into certain sectors or companies that have trouble refinancing.

“High yield is priced to perfection, so if everything goes okay you get compensated but, if that’s not the case, investors are not getting compensated. This translates into very tight spread,” she explained. 

5yr cumulative default rate

 

Source: Rathbones

Another way to look at it, she said, is by looking at the implied default in the market, which is currently lower than 1.75 per cent and is set to continue decreasing.

“The forecast for June 2018 is that the market will price at 0 per cent default rate, which is extremely rare in high yield,” she noted.

“The market is very complacent about the risk of default in the high yield universe, which we think has been driven by the chase for yield.”

She added: “Yields in US Treasuries and other government bonds [are] backing up, they suddenly start to offer more yield. But we don’t know when investors will start to switch from high yield into US Treasuries.

“So, when the yield differential becomes minimal then people may just buy US Treasuries; [they] are a much safer asset – you don’t get any credit risk.

“This will result in outflows in high yield, which will lead to spreads going wider. We will then start a vicious cycle.”

As such, Cazalis said the team has decided to reduce the fund’s allocation to global high yield bonds and emerging market bonds, where they also feel valuations have become expensive.

The reduction in allocations to high yield and emerging market bonds will help outperformance while also protecting the volatility of the portfolio, according to the manager.


 

“Whenever you see high yield or emerging markets moving quickly, you often see liquidity disappearing,” she said.

“In order to limit volatility, we have decided to develop a core strategy with minimum and maximum allocation to each asset class.”

Cazalis said the structure of the fund helps the manager move into and out of areas quickly, with around 50 per cent of the portfolio invested in other funds.

Elsewhere in the fund, the team has moved to an underweight position in duration, a decision they based on strong performance of the UK economy and the view that there could be a correction in UK gilts and had taken profits more recently.

The fund manager said they were also at their maximum allocation to UK corporate bonds as they continue to find very good value in financials, particularly subordinated bank and insurer debt.

“We continue to think both insurance and banks subordinated offer value over senior debt, since, for a given duration, you get a higher spread. And higher spread means higher yield,” she said.

Currently, 35.21 per cent of the fund’s asset allocation is to UK corporate bonds, 15.77 per cent is to UK government bonds and 15.45 per cent to global high yield bonds.

Cazalis added: “We are not chasing risks, so we are one of the most defensive funds in the sector.

“It’s managed like a total return portfolio as opposed to just trying to beat the benchmark, which has really helped performance specially when there’s tough time in the equity market.”

Performance of fund vs sector over 3yrs

 

Source: FE Analytics

Over three years, the £108.4m fund has delivered a 13.46 per cent total return, compared with a 9.74 per cent gain for the average sector fund, as the above chart shows.

The fund has an ongoing charges figure (OCF) of 0.83 per cent and a yield of 2.50 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.