Policy tightening and a weakening macroeconomic backdrop are starting to have an impact on bond markets and as such investors should expect lower returns this year, says Invesco Perpetual portfolio manager Rhys Davies.
The manager said last year’s strong economic environment means central banks are more likely to raise interest rates this year, which in turn could hit high yield markets.
He added that there are questions being asked about the strength of European markets and whether the current weak data is temporary or something more permanent.
Growth in the eurozone for the first quarter of this year was at its lowest since the third quarter of 2016, according to Davies, who co-manages the Invesco Perpetual Enhanced Income and City Merchants High Yield Trust investment trusts.
Turning to the US, Invesco’s Davies said the positioning of the yield curve is something that is stirring debate among fund managers and analysts. The US yield curve has been flattening recently as the Federal Reserve has pushed up short-term rates.
Previous cycles have shown that whenever the yield curve becomes negative - when the one-year US Treasury yield is higher than the 10-year US Treasury yield - a recession follows within the following two years or as early as six months afterwards as shown in the chart below.
US yield curve chart
Source: Federal Reserve of San Francisco
“So, there is a degree of uncertainty around the macroeconomic backdrop at the moment,” said the fund manager.
Davies also said that yields in high yield markets are at unattractive levels for investors.
“We started 2018 with yields in the high yield market at exceptionally low levels after a very strong, uninterrupted rally from early 2016. That left the prospect of those yields falling further fairly limited,” he said.
He did say that yields have risen throughout the first half of this year but noted that they are still at historically low levels.
“Although yields have risen in the high yield market this year, they are still very low by historical standards,” said Davies. “And that does makes us being able to find appropriately priced bonds that much harder.”
His outlook on high yield markets has remained unchanged in recent months and he believes that yields are too low to sufficiently counter the risks of investing.
He noted: “If we’re thinking about an outlook in returns for 2018, I would say more than likely they’re going to be lower than in 2017.”
The Bloomberg Barclays Global High Yield index saw returns of 10.43 per cent in 2017, whereas this year the index is already seeing a loss of 1.83 per cent.
Performance of index since start 2017
Source: FE Analytics
However, the bond fund manager did say there were plenty of opportunities in markets particularly with regards to differentiation strategies, which he said has been lacking in markets in recent years.
“Differentiation is making its way back into high yield markets and that’s a good thing,” said Davies. “By that, I mean investors in the market are paying more attention to what’s going on with a company and actually responding to that.
“So, a company that has a disappointing set of results may actually see their bonds fall several points.”
Another opportunity Davies sees in markets is the potential for a market correction, which he said could be one of the best opportunities out there for managers.
“Although we haven’t had one for a few years now it does create a very good opportunity for us,” said Davies. “And I think the closed-ended nature of the two investment trusts puts them in a particularly good position to be able to take a long-term view and take advantage of a correction in markets.”
His approach to finding opportunities and value in his funds is done on a bond-by-bond basis. One way he does this is by finding bond issuers that are new to the market that the market isn’t aware of.
This could allow the bonds to be issued with higher yields than those bonds issued by companies that have previously come to the market.
Another way Davies finds opportunities is by looking at struggling sectors, he explained: “That may mean looking at bonds within certain challenged sectors where the bond has been brought down in price because it’s part of that sector, such as retail at the moment.”
However, the bond manager does not look at the market on a sector basis.
“We tend not to avoid certain areas of the markets of sectors unless we have very good reason to do so, such as environmental, social or corporate governance reasons,” he said.
“And that’s because we feel there are often opportunities, albeit at the right price, in any part of the market.”
But he admitted he is more selective in certain sectors like oil, commodities and chemicals and avoids companies in those sectors that have very leveraged balance sheets where the possibility for volatile earnings is greater.
Performance of trusts over 3yrs
Source: FE Analytics
The £184.4m City Merchants High Yield Trust, which Davies manages alongside industry veterans Paul Causer and Paul Read, has delivered a total return of 20.72 per cent compared with a gain of 27.42 per cent for the FTSE All Share benchmark index and a 31.01 per cent return for the average IT UK Equity & Bond Income sector peer. The trust is currently trading at a 0.8 per cent discount to net asset value (NAV), has a yield of 5.2 per cent, is not geared and has ongoing charges of 1.03 per cent.
The £120.3m Invesco Perpetual Enhanced Income trust, which Davies also manages with Causer and Read, has returned 16.25 per cent compared with a 13.81 per cent gain for the average IT Global High Income Equity & Bond Income sector peer. The trust is currently trading at a 1.0 per cent discount to net asset value (NAV), has a yield of 6.9 per cent, is 22 per cent geared and has ongoing charges of 1.24 per cent.