In the current ultra-low interest rate environment and with government bonds and investment grade credit offering next to no real yield, investors have been forced into the higher risk areas of the fixed income market.This has been a fruitful area for most fixed income investors because higher yielding bonds have been much sought after due to their decent income potential and lower interest rate sensitivity.
However Lundie (pictured), who manages the Hermes Global High Yield Bond fund, is concerned that too many investors have now dipped into lower rated credit, so he is moving his portfolio outside of this overcrowded area of the market.
“My view of the high yield market is that it is as consensual as it has ever been, by which I mean everyone is making the same trade,” he said.
“Broadly, I agree with the idea of avoiding interest rate risk, but I disagree with the way people are choosing to mitigate that risk. First, they are going short duration and focusing on the shorter end of the interest rate curve.”
“They are also going down in credit quality to pick up more of a spread cushion. Everyone is making those trades and that is when the red light should be flashing,” he said.
High yield bonds have rallied strongly recently and the vast majority of top-performing funds in the IMA Sterling Corporate Bond and IMA Sterling Strategic Bond sectors have been the ones with a high exposure to lower rated credit.
Performance of indices over 5yrs
Source: FE Analytics
However, Lundie says that this trend is unlikely to continue.
“Spreads on B and CCC rated credit are back to pre-2007 levels, that is to say not much,” he explained.
He is also concerned that if there were to be a severe spike in volatility, the liquidity could dry up in the overpriced high yield market.
The manager says that because of this, he is building a different sort of portfolio to the majority of his peers.
“Where we have gone is up in quality and we have increased duration by adding to the long to mid end of the interest rate curve,” he said.
“We are mitigating this duration risk by using government bond futures to hedge. These are normally used in investment grade land, but I see no reason why you can’t use them in a high yield fund.”
“We are also entering credit risk via CDS (credit default swaps), which means, unlike in bonds, we aren’t taking any interest rate risk.”
“What we are left with is a fund that has the same sort of interest rate sensitivity as most others in the sector, but with significantly higher quality.”
Lundie says that the major reason he is moving into higher quality isn’t because of concerns over increased default rates, which is normally the major risk facing investors in lower quality bonds – he says there is almost no chance of a spike in defaults over the next two years.
The main reason for this, Lundie says, is because there has been so much refinancing going on as “every man and his dog has come to the market” to take advantage of the low interest rates.
Lundie says the big problem that has made him change the make-up of his Global High Yield Bond fund is the majority of high yield corporate bonds are callable.
This means the issuer can buy the bond back after a certain time at a certain price, paying it off early.
The main reason companies do this is because bond prices have risen and rates have fallen and they can therefore pay off the current bondholder and refinance at a lower rate.
As an example, the manager says that if there were a high yielding bond that was trading at 105 cents to the dollar now, but was callable at 104 in a few months’ time, that bond-holder would find it difficult to find someone to trade with because the price would revert to the call price as that date came nearer, leaving investors with capital losses.
He says this is happening more and more in the high yield market and a huge number of companies have already begun to call their bonds back as soon as they can.
“People have been buying up single B and CCC credit, but now significant areas of those markets are trading above their call price, partly because of where government bond prices are, and therefore can’t go up anymore and have limited scope for any further capital appreciation.”
“When you buy lower rated credit, then you are effectively taking near equity-like risk. However, you wouldn’t buy an equity that you know has no real upside left,” he added.
Lundie took charge of the Hermes Global High Yield Bond fund at launch in May 2010.
According to FE Analytics, the fund has returned 39.45 per cent since then, making it the best performer in the IMA Global Bonds sector.
As a point of comparison, it has also beaten the IMA Sterling High Yield Bond sector over that time.
Performance of fund vs sectors since May 2010
Source: FE Analytics
The fund has a yield of 5 per cent.
Its AUM is £141m and Lundie says that having a nimble fund is crucial in the current environment, as larger funds are being forced into the primary market at unfavourable conditions.
“Size matters, fundamentally. Keeping a fund nimble is crucial,” he said.
“That is because larger funds are becoming forced buyers in the primary [high yield] market. Bankers and companies are winning the battle quite easily at the moment, purely because of simple supply-demand.”
The manager says this is a problem for larger funds as the issuers now have the ability to loosen the covenant on new deals, giving them more of the upside.
Lundie says bankers and companies are making the non-call period shorter and shorter.
Our data on Lundie’s Hermes Global High Yield Bond only shows its institutional share class.
However, it is available to retail investors on fund platforms.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
