High yield corporate bond funds – all you need to know and some expert recommendations

18th March 2014

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High yield bonds offer a higher income than conventional bonds – hence the term junk bonds and as that name suggests investors must be willing to take a higher risk that the bonds will default. These loosely divide into two main types: developed market high yield corporate bonds have been extremely popular, as investors have been willing to take on more risk for the lure of a higher income stream and the rate of corporate bankruptcy has been relatively low.

Investors have also sought out emerging market government and corporate bonds, again in pursuit of a higher yield, though their popularity has been significantly dented by the recent rout in emerging markets generally.

What is the range of fund strategies

Developed market corporate high yield bonds are found in the sterling high yield sector. Managers of strategic bond funds may also have relatively high weightings in the sector. There will also be funds focused on Euro and Dollar-based high yield bonds in the global bond sector. Emerging market government and corporate bonds now have their own sector, the IMA Global Emerging Market Bond sector.

Developed market high yield bond funds tend to be less sensitive to interest rates, and more sensitive to the performance of individual companies and the level of corporate defaults being seen in the market. Managers of this type of fund will usually be looking for the best risk/reward balance for individual securities. That said, some managers will be willing to move into lower-rated bonds in order to raise the overall income of the fund, while others will stick with bonds issued by companies that may only be a notch or two below investment grade.

Emerging market bond funds require different skills. The emerging market corporate bond sector is still in an early stage of development, so there are relatively few funds focusing on it. The majority of funds focus on emerging market government bonds so fund managers will usually be examining the credit-worthiness of a country rather than of a company. Fund managers will be making a decision on whether, say, Mexico is likely to be a beneficiary of US growth.

Recent performance

The two types of high yield bond have seen a significant divergence in performance over the last 18 months. Developed market high yield bonds have been supported by the demand for income in a climate of lower interest rates and the relative low rate of default among lower-rated companies. In contrast, emerging market bonds have been caught up in the poor sentiment towards emerging markets and the weakness of their currencies. After a strong run in the previous three years, performance for the sector has been very weak.

The average sterling high yield fund is up 110.5% over the past five years, with the top fund – the Invesco Perpetual High Yield fund – up 175.9% and the weakest fund – the Scottish Widows High Income bond fund – up 70.2%. The Marlborough, Baillie Gifford and Kames funds have all been top-performers. The top performers recently have tended to have higher exposure to the banking sector, which has performed well as economic expectations have improved, while the weaker funds may have been too cautious.

Over five years, the performance of the global emerging market bond sector looks reasonable, with the average fund up 32%. However, the past year has been painful for investors, with the average loss 15.5% and some of the funds down as much as 25%. The worst performance has come from those funds exposed either to the weakest and most indebted emerging markets – Turkey, Indonesia – or from those funds with high weightings in local currency (as opposed to dollar-denominated) debt. Currency losses have been very painful in some emerging markets.

 When does the funds perform well/badly?

High yield corporate bonds tend to perform well when the corporate sector is in good shape: balance sheets are relatively strong, few companies are going bankrupt and earnings are improving. In this respect, they will often follow the path of equity markets. They will tend to sell off significantly as a recessionary environment looms. In the last economic downturn, high yield bond funds lost as much as 40% peak to trough. High yield bonds have had a very strong run and history would suggest that returns will not be as strong over the next few years.

Emerging market bond funds will tend to rise and fall with sentiment towards emerging markets, which in turn will vary with economic performance of individual emerging markets. That said, the Chinese economy tends to exert an influence over all emerging markets.

Nevertheless, the income available from these funds can be very attractive and therefore if interest rates are low, they can have significant appeal.

How much of a portfolio for low/mid/high risk investor?

The amount of a portfolio to be directed to high yield bonds will largely depend on an investor’s desire for income. They are higher risk and therefore should only form part of a fixed income portfolio, particularly when it is to support retirement income. Nevertheless, they sit at the intersection between bonds and equities, offering a higher yield with a chance of punchy capital returns at certain times in the market cycle.

Popular funds

Top 10 by performance (5 year – %) – Sterling High Yield

Invesco Perpetual High Yield – 175.9

Marlborough High Yield Fixed Interest – 166.7

Baillie Gifford High Yield Bond – 144.2

Kames High Yield Bond – 138.7

Ignis High Income Bond – 123.8

F&C Maximum Income Bond – 121.9

Newton Global High Yield Bond – 121.4

Aviva Inv High Yield Bond – 118.7

AXA Pan European High Yield Bond – 118.7

Pimco GIS High Yield Bond Inst Hedged – 113.8

Top 10 by performance (5 year – %) – Global Emerging Market bond

Invesco Emerging Markets Bond – 90.9

Pimco GIS Emerging Markets – 69.8

Pictet Global Emerging Debt – 65.0

HSBC GIF Global Emerging Markets Local Debt – 51.2

Baring Emerging Markets Debt Local Currency – 43.4

Capital International Emerging Markets Debt – 33.1

Threadneedle Emerging Market Bond Ret – 31.4

Investec Emerging Markets Local Currency Debt – 31.4

MFS Meridian Emerging Markets Debt – 30.8

Pimco GIS Emerging Local Bond I Unhedged – 30.8

Key questions investors should ask themselves

Am I willing to tolerate high volatility?

Do I want to stick to the UK, or look to Euro- or dollar-denominated bonds?

Am I willing to take risk on emerging markets?

Do I need income? Am I getting paid a high enough income to take the risk on lower quality companies?

 Expert views and recommended funds

Gary Potter, joint head of multi-manager at F&C investments

“While this should be a good environment for high yield, it is largely in the price and investors are not getting much additional compensation for the risks they are taking. In high yield, investors need to ensure they are getting access to a team with good credit analysis skills. In this way it is difficult to ignore the strength of teams such as those at Kames, Neuberger Berman and Legg Mason.”

Funds

Kames High Yield Bond fund

Neuberger Berman High Yield Bond fund

Legg Mason Western Asset Global High Yield

Gavin Haynes, investment director, Whitechurch Securities

“As the economic climate has improved investors have been more willing to invest in the riskier end of the bond market and get the higher yields that high yield corporate bond funds offer. Over five years the total return from the IMA Sterling High yield bond sector has been 110%. However, past performance is no guide to future returns and investors cannot expect to see the returns from high yield bond funds that they have enjoyed over the past five years.

“However, I still see pockets of value in high yield bond funds. Although this area of the bond market does carry greater credit risk, it has traditionally been less sensitive to rising interest rates compared to other areas of bond markets. Providing the global economic backdrop remains benign I expect defaults to be low and investors to be rewarded for taking on the extra credit risk.”

Funds

Kames High Yield bond fund

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