High-yield debt is higher risk but can offer rewards

Junk bonds may still be an attractive option for income investors

INCOME investors have been hard hit by the financial crisis. The response of policymakers – injecting cheap money into the economy through monetary easing – has squashed yields to record lows. Now “safe” assets – like gilts or cash – return negative real yields.

The challenge for investors is to find meaningful income. And this is a reason why the high-yield debt sector has been receiving attention.

A high-yield bond is a form of debt that is issued by a company with a low credit rating. Investors are compensated for taking on higher risk by a higher yield. They are sometimes referred to as “junk bonds,” but don’t be misled by that label.

UK retail investors injected almost £550m into the sector last year, according to the Investment Management Association – almost double the figure in 2011. And given that the average fund in the sector rose in value by 19 per cent in 2012, it is easy to see why.

Don’t expect similar performance this year, however. Ben Pakenham of Aberdeen Asset Management says “the sector doesn’t look as easy as 2012,” when average yields were 10 per cent. Typical yields currently range between 5 and 8 per cent.

So is there still a case for investing in the sector? Azhar Hussain of Royal London Asset Management says that investors need to consider how much volatility they are prepared to tolerate. “The fixed-income nature of high-yield can protect you from the sort of volatility that you encounter with equities.”

His point was illustrated this week. The uncertain outcome of the Italian elections rocked European equities, highlighting the political risks that remain in the Eurozone.

European high-yield bonds maintained a low default rate last year, however, at around 1.8 per cent – lower than in the US. And this year, Moody’s forecasts that default rates will continue to remain low, at 3 per cent.

Ironically, monetary easing has aided high-yield corporates by reducing their cost of funding. Hussain says “this allows companies to refinance at attractive rates, helping to deter potential defaults”. And given that quantitative easing isn’t going away anytime soon, it will support the sector.

Unsurprisingly, companies have rushed to refinance their debts. Data from Fitch Ratings shows that European high-yield bond issuance was €60bn (£52bn) last year – up 47 per cent from 2011.

Since the onset of the crisis, corporates have been more conservative; by hoarding cash and culling excess staff, they are leaner. And this is attractive to debt investors.

But a fall in the yields of the junk bond sector has led to questions about whether it is in a bubble. This talk may be premature, however. The spread between government bonds and high-yield debt is about 5 per cent, which is around its long-term average. And Pakenham says “these spreads are still compensating investors for the risks that they are taking”.

And compared to investment grade bonds, high-yield debt is less vulnerable to spikes in government bonds yields, and interest rate rises. Both are expected to eventually start edging upwards over the next few years, and Pakenham believes that high-yield’s better spread offers a cushion to absorb these rises.

Most retail investors will not have direct access to the high-yield debt market, so they will need to invest in a fund to gain exposure. And given the complexities involved in debt markets, the actively-managed style of institutional investors is more appropriate.

Institutional investors are able to meet with the management of a company and quiz them about capital structures, and base their strategies around this. This approach allows them to identify subtle risks.

Currently, one of these risks is that companies issuing debt may misuse the proceeds – through inappropriate mergers and acquisitions, for example. Pakenham cites the recent example of Virgin Media, which was acquired by Liberty Global – a company with a lower credit rating. “That isn’t good for high-yield investors,” he says.

As a result, fund managers evaluate the covenants that are attached to debt issuance. High-yield debt often has more stipulations about how and when a company is able to change its capital structures (like change of ownership clauses, for example).

But investors still need to look at individual fund managers, and be aware of the different investment strategies they employ: short duration (where debt matures earlier), or long duration.

Shorter duration strategies may be attractive to risk averse investors, since the longer you are invested in debt, the more risk you take on (of interest rate rises, or even default). Before investing, read through the fund factsheets to see the remit of the fund.

High-yield companies carry higher risks. But despite this, low default rates, low volatility, shelter from short-term political risks, and potential high single-digit yields, keep high-yield debt in a “sweet spot,” according to Hussain. And in this environment, where else can you find decent real income?