Understanding the Risks of High Yield Bond Funds

As investors continue to search for yield in this low-rate environment, high yield bond funds are certainly alluring but investors need to be cognisant of the risks

Morningstar OBSR analysts, 12 July, 2012 | 3:57PM

As investors continue to search for yield in this low interest rate environment high yield bond funds are certainly alluring, although investors need to be cognisant of the risks. The third quarter last year was one of the worst on record for high yield and the brutal sell-off was precipitated by heightened uncertainty surrounding the viability of the eurozone and the strength of the global economic recovery. The negative ramifications of this for corporate earnings and default expectations led to a re-pricing of risk assets which hit the sector hard. The experience of last year surely brought back memories of 2008 when the average fund in the IMA Sterling High Yield sector fell around 25%, however patient investors were rewarded handsomely in 2009 as they returned 48%.  Again the same was true this time as we saw a sharp rebound in the market in December 2011 on the back of the announcement of the LTRO and improving economic data. Despite this rally the relative case for the asset class remains strong given US Treasury yields are at extremely low levels and investment grade yields are near all-time lows. At Morningstar OBSR we believe higher yielding bonds present the prospect of higher returns within fixed income however with the “risk-off” trade possibly running further we view this as a long-term investment.

The case for high yield is compelling as it provides regular income through coupon returns, capital protection relative to equities and limited interest rate exposure compared to other fixed income markets. Looking at the US high yield market between 1985 and 2010 the income return was 10.75% on average per year, which is particularly attractive in the current environment. More generally however the potential for capital loss in the sector is always high and one of the key factors to assess this is the default rate. Default rates were under 2% in 2011 which was well below the historical average of 4%. Many commentators came into 2012 expecting default rates to remain low and even in the event of a developed world recession they were expected to be lower than in previous recessions. The main argument posed for this was the significant new issuance activity over the last few years, with record primary market activity in the US and Europe, which was used predominantly to refinance debt as opposed to acquisition financing or LBO activity. Despite this one must bear in mind this is a very economically sensitive sector and as recent economic data has deteriorated and concerns surrounding the eurozone have escalated yet again, the second half of the year could prove challenging for companies. Historically in periods of risk aversion credit spreads have widened substantially, and although they have ultimately overcompensated investors for the actual levels of default rates, the volatility in the short term can be extreme.

The global high yield market is dominated by the US which makes up around 80% of the market. European companies have traditionally relied on bank funding however over the last few years as these banks have been forced to deleverage, companies are increasingly looking to the corporate markets to raise capital.  This should lead in time to a wider and deeper European high yield market. One of the most prominent features in the market over the last few months has been the divergence between US high yield and European high yield spreads as investors have sought a higher risk premium for European bonds. M&G believe default rates for the European high yield market will average 6% over the next five years, although they note valuations already compensate you for this risk with a default rate of over 8% already priced in and therefore they are focussing on the active stock selection and defensive industries within the sector.

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