As a result of the ultra-low interest rate environment and persisting headwinds following the financial crisis, yields on higher-rated government and corporate bonds have been pushed lower, causing a number of managers to start searching for high yielding bonds to boost their income.
This has been a profitable strategy, as funds which have tended to have a higher weighting to lower-rated credit have topped the IMA Sterling Strategic Bond sector over the past five years.
However, Stewart – whose five crown-rated Baillie Gifford Corporate Bond fund sits in the sector – warns that the search for yield has gone too far and that investors should be very aware of the risks certain funds now carry with them.
“Over the last three years, we have seen some strong returns from CCC-rated credits and that is not an area where this fund would go fishing,” Stewart said.
Performance of index over 3yrs
Source: FE Analytics
“You may have heard of the search for yield going on in the credit markets currently and there has been a move into non-traditional areas by certain funds and so if I were sitting on [the investor’s] side of the fence, and I saw funds with 6 per cent plus yields, I would really be asking some questions.”
Stewart didn’t name any funds in particular but, according to FE Analytics, there are a handful of funds in the IMA Sterling Strategic Bond sector which yield above 6 per cent and they include the likes of JPM Income (6.99 per cent yield), Royal London Sterling Extra Yield Bond (6.82 per cent) and OId Mutual Monthly Income Bond (6.21 per cent).
In an article next week, FE Trustnet will examine how risky the highest yielding funds in the sector are but Stewart says investors need to be well aware of the potential dangers.
“There have been three classic reaches that have been going on. One is that people have started to buy CCC or below rated credits – so plumbing the depths of the market,” the manager said.
In his presentation, Smith showed a graph of default rates in different rated bonds within the credit market since the early 1980s using data from Moody’s.
It revealed that though default rates from high yield bonds have tended to be low for long periods of time, they have spiked massively on four occasions over the period – 1984, 1987 to the early 1990s, during the early 2000s and in 2008.
Though many experts expect defaults to remain low over the coming years as companies have been able to refinance themselves very cheaply due to low interest rates, Stewarts says complacency is creeping into the market.
“What you see is that everything is quiet for a reasonable period of time then suddenly you see a significant spike in default rates and the loss rates in the CCC and B categories tend to be quite high,” Stewart said.
“So things are quiet just now, but it doesn’t tend to last that way.”
Stewart also showed a table of the different rated bond’s average credit loss rate per annum and their average yield between 1982 and 2013, which is shown in the table below.
Source: Moody’s
“In BB and BBB, the loss rates on average are quite low but it starts to jump up when you get into the lower depths of the high yield market. Indeed, when you look at the CCC category, you are rarely getting sufficient compensation – in terms of the yield – to match that long-term default rate.”
Apart from buying lower-rated bonds, Stewart says managers are taking risk in other ways.
“The other category that people have been purchasing have been cat [catastrophe] bonds. This is when insurance companies seek to offload risk; so an example would be if you had a Texas tornado or a Florida windstorm, they pass it out into the markets to reduce their overall exposure.”
“In the past, these bonds were bought by hedge funds and catastrophe specialists, now by pension funds and institutional buyers. The yields have come down as a consequence and they have basically gone mainstream.”
“Now, the problem with predicting the weather is, effectively, you are trying to predict the weather.”
“Given where yields are now within that category, the likes of Warren Buffett have been taking money out. If the attachment level is reached in some of these bonds, you can be completely wiped out.”
The final category which Stewart says managers have been chasing riskier asset is additional tier one debt, a type of contingent convertibles, which he describes as the next generation of capital for banks.
“This new generation capital is great for banks, but it is less good for the purchasers of those instruments because the terms are not as good as the old subordinated financial paper. They sit between debt and equity, so we have seen aspects where they converted into equity or they have permanent write-down; so if they are triggered, that’s your bond gone.”
He added: “These do come with higher yields and some managers have been putting them into their portfolios, but beware of the risks and you have to be very selective.”
Stewart joined Stephen Rodger as co-manager of the £420m Baillie Gifford Corporate Bond fund in June 2010.
According to FE Analytics, the fund – which is roughly split 70/30 between investment grade and high yield – has been the fifth best performing portfolio in the sector over 10 years with returns of 77.91 per cent.
Performance of fund versus sector over 10yrs
Source: FE Analytics
It has been top quartile over one, three, five and seven-year periods and is considerably outperforming so far in 2014 due to its high weighting to higher quality, longer duration, bonds.
Baillie Gifford Corporate Bond has a yield of 4.3 per cent and an ongoing charges figure (OCF) of 0.54 per cent.
