Phillips, manager of the Baillie Gifford High Yield Bond fund, says yields are at historical lows in the high yield market and it is difficult to find bonds that will actually appreciate in value.
The manager says if a large number of investors who have flocked to high yield bonds in recent years suddenly exit, investors will feel the pain.
“There isn’t a compelling opportunity to invest in high yield bonds at the moment,” he said.
“If there’s a mass exodus, because there’s a bubble, if there is a bubble, there could be mark to market pain felt by those who currently own high yield bonds.”
“There has been an abnormal period of [high yield] being just an absolutely wonderful investment for everyone involved with not that much volatility and going in one direction, perhaps apart from a wobble in 2011.”
Phillips says it would be unrealistic to expect high yield to continue its single-direction upward movement.
“High yield is more akin to equities than government bonds,” he said.” If you own high yield you should be prepared for volatility. But I don’t think [an exodus] causes a huge spike in the default rate, which is the more important metric.”
“People talk about a reduction of QE [quantitative easing] and the impact that could have and interest rates and the subsequent impact that could have on the high yield bond market if people try to exit for safe instruments on a higher yield.”
“You hear phrases like tourists in the high yield bond market in the press quite a lot. Sure, I think it’s a cyclical asset class and people have been persuaded in by a low interest rate environment, but I also think the institutional involvement in the asset class has increased quite a lot as well.”
However, he says that because banks have all but disappeared from lending over the last five years, the European high yield bond market is a vital source of lending for companies, which is why he doesn’t think it will disappear.
He says he would start to worry if the high yield market closed for two years, but he points out that even in the worst economic conditions in recent history – the credit crisis of 2008 – the high yield bond market didn’t die out.
But Phillips adds the huge amounts of new issuance into the high yield market is likely to make the sector even more sensitive to rising interest rates.
“We’ve already seen huge amounts of new issuance into the market. Last year was a record year for new issues into the European high yield market,” he said.
“The one distortion, if that’s the right word, is companies are issuing bonds at much lower coupons.”
“Now the interest rate is much lower, so the higher coupon bonds that were issued a couple years ago – two or three years ago – start to mature, replaced with lower coupon bonds then that will make high yield bonds a more interest rate sensitive market because lower coupon bonds have higher duration.”
However, Phillips says this isn’t a concern for investors like him who have a longer term view. While interest rates may shift in the short term, he says the thing high yield bond investors really need to focus on is the default rate.
“We do not make any investment decisions based on interest rates and what they will be,” he said.
“By building a diverse portfolio with, broadly speaking, resilient companies – that’s not necessarily just lending to the most defensive businesses out there – we’ll do our own proprietary research and come up with a view on companies that are resilient and that market may disagree and at certain periods in the cycle the market may really disagree that they are resilient businesses, but if we’ve done our research properly and if we size the position properly, it should be ok.”
Phillips says what really drives returns in the high yield space is the default rate and investors shouldn’t be overly concerned about short term paper losses.
“We’re prepared sometimes not to be in the first-quartile over a three month period. If we’ve done our work properly, we’ve built a portfolio where are large positions are in the companies we have the most faith in, then our macro view shouldn’t really matter.”
“At some point default rates will increase. When that happens, I don’t know. My job is trying to avoid as many of them as possible.”
The fund is currently yielding 4.2 per cent, making it one of the lowest-yielding funds in the sector. The highest-yielding portfolio is the Marlborough High Yield Fixed Interest fund, which is paying out 7.11 per cent, according to FE Analytics.
However, Phillips says the strategy of the fund is not aimed toward providing a targeted yield.
“We’re trying to achieve a high level of total return from a diversified portfolio of sub-investment grade bonds. What we’re not trying to do is set out a specific level of income for people to benefit from.”
“We’re trying to create a portfolio that will broadly match the kind of returns you would expect to see in the high yield universe as a whole. Hopefully over the long-term we can outperform what is our index.”
The managers take a three to five year view when lending to companies, which Phillips says is a longer term view than the majority of the market.
He adds that this approach means the turnover in the portfolio is low, which helps keep costs down for investors.
“We actually think that one good way to provide value for your clients is to not trade very often. You end up giving more value to the shareholders and the bankers in the City in London who earn commissions from us trading, so we try and reduce that as much as possible,” he said.
Though Phillips is wary of the high yield bond space, the Bailie Gifford High Yield Bond fund has outperformed the IMA Sterling High Yield Bond sector over the last one and three years.
Since Phillips and co-manager Robert Baltzer took over the portfolio in June 2010, the fund made 47.22 per cent, more than 10 percentage points ahead of the sector, but lagging its sterling hedged Bank of American Merrill Lynch European Currency High Yield Constrained index, which gained 53.52 per cent.
Performance of fund vs sector and index since 2010
Source: FE Analytics
The fund is, however, significantly less volatile than its benchmark. Over the last three years, the fund has an annualised volatility score of 8.75, while the index scores 11.16 per cent. The IMA Sterling High Yield sector has annualised volatility of 8.02 per cent over the period.
Bailie Gifford High Yield Bond has ongoing charges of just 0.4 per cent.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
