High yield bonds should be a structural part of an investor’s portfolio rather than just a tactical play, according to FE Alpha Manager Mike Scott. 
The manager of the five FE Crown-rated Schroder High Yield Opportunities fund said not only has the sector been a better place to be than equities historically but that it should remain compelling going forward.
“We think the asset class is an attractive one, not just from a tactical perspective,” the manager of the £531m fund said.
“Often when people think about high yield they say it is a great tactical investment that you can time well and while that certainly has some merit to it, I also believe that high yield has a structural place in a long-term portfolio.”
Performance and other metrics of asset classes over various timeframes
Source: Schroders
As the above table shows, the return profile for European high yield bonds has been better than that of both European and UK equities over the last decade on an annual basis while over the last five years high yield bonds have returned 7.5 per cent annualised – a similar return to that of European equities (7.97 per cent).
In contrast, the maximum drawdown (the most an investor could have lost if buying and selling at the worst possible moments) of high yield bonds is significantly less than equities.
Over the last three years, the maximum drawdown of European high yield bonds has been just shy of 7 per cent while European equities have experienced peak to trough drawdown of 27 per cent despite both asset classes delivering comparable returns, Scott noted.
“I think you can say the same over much longer time histories which would incorporate more extreme periods of volatility,” he added.
The reason for this smoother ride is the nature of the asset class, which involves collecting a coupon every month.
“With a high yield bond we are investing in relatively riskier companies but we are compensated for that and it is the harvesting of that high coupon or high spread that really gives it very strong risk-adjusted characteristics in comparison to other risky assets such as equities,” Scott said.
“That is why you typically get a much more attractive payoff than you do in equities where you assume a lot more risk to your capital.”
Despite this, many investors attempt to time the market, using it as a tactical asset allocation rather than a structural one, but from a more tactical basis when is the sweet spot for investing in credit and high yield?
Scott noted: “Typically it is usually in a moderate growth environment and this intuitively makes sense because the companies in which we invest tend to be quite small.”
As the below chart shows, when growth in the US is 3 per cent or more equities tend to outperform; if GDP growth is between 1 and 3 per cent, high yield bond strategies have a greater chance of outperformance.
Source: Schroders
“When growth is on a moderate trend it means that management teams are not necessarily going to be aggressive with their balance sheets, they are not going to leveraging up and indulging in M&A,” he said. “What they are going to do is favour creditors over equity holders.”
This trend, which has been in place for the past few years and has seen the asset class gain in popularity, should continue with long-term drivers such as an ageing population and large amount of global debt likely to keep growth subdued.
“Being a bond guy, I am going to be more downbeat than my equity counterparts but we think these are long term-trends that will keep growth in a lower ebb,” Scott said.
While the backdrop remains positive then for high yield, some remain concerned that the bonds in the asset class are higher risk and the companies issuing them have a higher likelihood of default.
“Defaulting is the nature of the asset class,” Scott said, adding that for investors worried about this the key is to look at active management.
“You cannot get around the fact that not all high yield companies are equal. They are typically quite small companies with £50m to £250m in EBITDA [earnings before interest, taxes, depreciation and amortisation] so can be quite influenced by prevailing factors whether that’s economic or any other drivers that businesses meet.
“That requires managers to be very bottom-up and given that a lot of the active part can be skewed towards private companies that is whether they are private equity-owned or family-run businesses, you need to have a deep bank of research resources.
“Those funds that offer passive means to gain exposure to the market have been shown to woefully underperform active managers in high yield.”
Scott has run the Schroder High Yield Opportunities since 2012 during which time it has returned 59.72 per cent, ahead of the IA Sterling High Yield sector average by 23.77 percentage points.
Performance of fund vs sector since manager start
Source: FE Analytics
While the fund is predominantly invested in high yield, the manager noted that he is also has 10-12 per cent weighted to investment grade bonds.
“The economic backdrop is quite a favourable one for high yield company fundamentals as we’ve got strong, synchronised global growth and this means that defaults are likely to remain low next year. However, this is probably factored into spreads – particularly in the European market,” he said.
“So, I do own some investment grade in the fund. In the portfolio I have more of a quality tilt – it is a single ‘B’, low BB-type credit quality as I am not sure this is the environment where you want to be fully invested in CCCs.”
The fund is 43.5 per cent weighted to European high yield bonds with 26.8 per cent in the UK and 14.2 per cent in the emerging markets.
It is 37.7 per cent weighted to bonds with a BB grade – the top end of high yield, with 29.5 per cent in B rated debt and 15.1 per cent in CCC debt.
The fund has a yield of 6.36 per cent and a clean ongoing charges figure (OCF) of 0.72 per cent.