High yield bonds are the natural next step up the risk ladder for investors who have traditionally sheltered their assets in government and investment grade bonds, rather than going all out into equities. The manager says that although he is generally bullish about the asset class, he does think there is a risk from hot money investors need to be aware of.
“High yield is becoming increasingly fashionable,” he said. “There is a huge amount of money looking to be put to work.”
“It may be a small allocation by their standards, but it’s a massive allocation by ours because investment grade dwarfs high yield,” he said. “Those guys can be pretty flighty.”
“If investment grade owners of high yield sell, it can be really quite lumpy. [Those types of investors] can be a bit panicky. We saw BB bonds fall 5 or 6 points in June last year.”
Pakenham says the signs are evident in the fact that many deals come through with lower yields than the team is told to expect and adds it is a seller’s market.
“Every deal is oversubscribed. There are a lot of people chasing limited assets, which does create price pressure. If that were to change, obviously it would have a negative impact and we are worried about that,” he said.
This threat is the primary reason the Euro high yield team at Aberdeen has shifted the focus of the fund away from investment grade, BB-rated, high-yielding bonds and into B-rated assets, which it feels are too exposed to government bond risk and the threat of a mass sell-off.
“We have our lowest weight to BB relative to the market than ever,” he said.
However, he is also reducing exposure to assets further down the risk scale, trimming the number of CCC-rated bonds in the fund because he feels investors aren’t being paid enough to take on that level of risk.
“We went from a barbell approach to a single-B focus. I’m happy to be focused on single-B and CCC, but less CCC,” he said. “We’re reducing credit risk by reducing our weighting to CCC and reducing government bond risk by reducing our weighting to BB.”
Another headwind on the horizon for bonds is rising government bond yields, which could also pose a threat by the end of the year.
“It’s an inevitability that yields will go in one direction, and that concerns me a bit,” he said. “If we were to see a spike in government bond yields, we could see another June [the sell-off in bonds occurred in June last year].”
However, he doesn’t expect a correction to be too dramatic and says the high yield market is now in a far better place than it has been in the recent past.
“Valuations are not hugely over-stretched, but yields are pretty low by historic standards. We could see a correction but I wouldn’t expect it to be too dramatic,” he said. “We’re in a much less risky place than we were two years ago, even though we’re less rewarded.”
Pakenham explains that high-yield bonds have traditionally been more positively correlated to equities, while they have often been negatively correlated to government bonds. However, he expects to see a shift.
“The correlation between high yield and government bonds will become more positively correlated,” he said.
However, the manager still feels high yield bonds, particularly in the single-B space, are a far more attractive place to be than investment grade bonds.
“I don’t expect yields to dramatically fall from here, let’s say they’re about 4 per cent,” he said. “Yields are at all-time lows, but spreads are nowhere near all-time lows.”
“I’d much rather own high yield because of the inevitability that government bond yields will go up in one direction.”
The manager says that corporates in Europe are in especially good shape as lending standards are easing in the region, balance sheets are in good shape and the ability of firms to pay their debts is very high.
However, he says he is starting to see some warning signs arising in the market – namely the deterioration of quality of new issues and increasing LBO (leveraged buyout) activity.
“LBOs tend to come with more debt, which is obviously negative,” he said.
He is starting to see a rise in high-yielding instruments called PIK-toggle notes as well, which he says effectively offer a cheap way for companies to issue equity by having the option to pay interest in cash or in more bonds.
“We’re ignoring them but it is a signal things are starting to get a bit more toppy,” he said. “More LBO activity would also be a warning sign. I don’t think it is a short-term problem, but it would signal the beginning of the end.”
Pakenham says if there were a correction, the team would take the opportunity to move down the risk scale and pick up more CCC-rated holdings, because if valuations were cheaper, taking on more risk would appear more attractive.
The £33.6m Aberdeen High Yield Bond fund has an attractive yield of 6.8 per cent, the third highest in the IMA Sterling High Yield sector, behind the Newton Global High Yield Bond and Marlborough High Yield Fixed Interest funds.
The fund has also performed well relative to its peers, particularly since the market correction last June, though it has lagged behind its ML European Currency High Yield Constrained Index Hedge GBP benchmark.
The fund has made 6.46 per cent over the past year compared with 6.04 per cent from the sector and 9.54 per cent from the index.
Performance of fund vs sector and index over 1yr
Source: FE Analytics
The fund still trails the sector and index since launch in March 2011, having gained 15.11 per cent.
The highest sector weightings in the fund are to consumer products and services, with 19.4 per cent and 17.4 per cent, respectively.
The fund holds debt in the world’s largest brick manufacturer Wienerberger, Canadian multinational aerospace and transportation company Bombardier, and Lloyds.
Aberdeen High Yield Bond requires a minimum investment of £500 and has ongoing charges of 1.4 per cent.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.