With UK interest rates remaining at post-financial-crisis highs, and inflation continuing to nudge lower, fixed income assets still offer attractive levels of prospective returns, even after taking into account the effects of inflation.
Given this backdrop, corporate bond funds are naturally of interest for investors looking to generate additional income to that available on government bonds, money market funds and deposit accounts.
So, how should investors assess their options across credit markets? Is this the time for high yield funds? Or are investors better off with investment grade credit?
Well, as ever, the prospective return profile of any corporate bond fund relies on two risk factors, interest rate risk (duration) and credit risk.
Investment grade funds typically have higher levels of duration relative to high yield funds, as their higher-quality investee companies can issue their debt over longer time periods. This means that the price of investment grade bonds is more sensitive to movements in interest rates.
As, when interest rates rise, the future schedule of income payments on existing bonds becomes less attractive, resulting in a fall in the price of the bonds, and vice versa as interest rates fall.
High yield funds, by contrast, invest in bonds of companies that typically issue over shorter time periods, given their longer-term prospects are less clear to lenders. Movements in interest rates therefore have less of an impact on the return profile of high yield funds.
Credit risk, on the other hand, is naturally higher in high yield funds, as these lower-quality companies are more likely to renege on their repayment schedules. This higher credit, or default, risk necessitates a higher premium for investors to lend to these companies, hence the label ‘high yield’.
The structural benefit of holding high yield bond funds over investment grade bond funds is therefore the lower duration and higher yield on offer, whilst the structural drawback is the higher default risk, and therefore potential for greater volatility and losses during credit events.
Within the current macro environment, if the economy remains stable, interest rates hold and corporate defaults remain low, then high yield bond funds will almost certainly continue to outperform their investment grade equivalents.
However, should interest rate expectations fall and recession concerns build, high yield funds should struggle, and investment grade funds outperform.
Within some of our AJ Bell portfolios (risk profiles 1-4) we reduced our high yield exposure early in 2024, after having a relatively high allocation throughout 2023.
This followed a number of years where it has been the strongest performing area within fixed income markets given its lower interest rate and higher credit risk profile.
Essentially, at this point, we felt valuations had become somewhat tight in the market and that high yield no longer offered the relative value it once did versus other areas of the fixed income universe, particularly if developed market economies struggle under higher interest rates.
Meanwhile, whilst not enamoured by valuations within investment grade corporate bonds, we do continue to prefer them for the resilience they typically offer in economic downturns, alongside their higher exposure to interest rate risk at a time when interest rates are likely at their highs of the cycle.
We do continue to hold high yield within these portfolios, and, short of a large move in valuations, we are unlikely to make any further changes to the allocation in the coming quarters.
For higher risk portfolios that carry a narrower selection of fixed income (risk profiles 5 and 6) we have left the allocation to high yield unchanged as we feel its overall yield retains the ability to provide an ‘equity-like’ return but with lower volatility.
Two active funds we like to use to access the credit markets are the Artemis Corporate Bond and the Invesco High Yield funds.
Well-known bond investor Stephen Snowden and his team have done a fantastic job since the 2019 launch of the Artemis Corporate Bond fund, consistently delivering outperformance for investors from both a sector allocation and security selection perspective.
The fund is typically run with more risk than its index, with the risk allocation fluctuating between interest rate and credit risk depending on the team’s views.
That said, the managers are committed to keeping the fund’s duration within a fairly narrow band (1.5 years) of that of the index. This ensures the fund’s return profile remains equivalent to that of wider fixed-income markets.
Meanwhile, Tom Moore invests his Invesco High Yield fund across a combination of high yield bonds that are more highly rated (BBs), including sectors such as financials, and undervalued bonds he deems to be special situations.
Given the volatility of the latter two components, the fund is typically at the more volatile end of its market. The manager’s positioning in financials has been particularly additive to relative returns over the years, and he continues to see good opportunities in the sector.
Paul Angell is head of investment research at AJ Bell. The views expressed above should not be taken as investment advice.