Bond markets are full of idiosyncratic risks at present, but the valuations of high-yield bonds mean the capacity for that asset class to offer protection against a rapid increase in inflation is “limited” compared to recent history, according to Mike Scott, who runs the £851mn Man High Yield Opportunities fund.
That fund is the top performer in the IA Sterling High Yield sector over the past five years, having returned 83 per cent, compared with 48 per cent for the average fund in the sector.
Despite being a high-yield bond manager, Scott readily admits that the prices of such bonds, as expressed via the spread offered over government bonds, is expensive right now.
Scott says spreads are in the “bottom quartile” relative to history.
The spread is the extra yield one receives for investing in high-yield bonds, which come with heightened credit risk, relative to owning developed market government bonds, which carry little credit risk.
A narrow spread between the two asset classes implies that high-yield bonds are priced highly, as yields move inversely with price.
The fund manager says the reason high-yield bonds have traded at such high valuations, in common with many other asset classes, is as a result of the low interest rate environment and high government deficits, which have created extremely high levels of liquidity in the world.
That liquidity environment is now changing, Scott notes, as quantitative easing is being unwound and pandemic-era government stimulus packages end.
Scott’s view is that as the liquidity environment changes, owning blanket exposure to the asset class, or to specific themes within fixed income such as duration, is less likely to be effective, with the choosing of particular bonds more likely to be the driver of returns.
Scott says: “The stimulus programmes mean the normal market cycles have been longer. The result of that coming to an end is likely to be a wider dispersion of returns, as spreads are generically expensive. We don’t trade duration or currencies. We spend most of our time looking at the valuations of companies, we want to ensure there is a margin of safety.
“Given that dispersion, it is likely that high yield will offer less protection in the event of a market shock than has been the case during other cycles.”
High-yield bonds are typically associated with protection against inflation risk.
This is because the yields may look relatively more attractive, relative to government bond yields, at a time of higher inflation, but also because the higher inflation may be a signal that economic growth is picking up, and so the economic sensitivity of high-yield bonds comes to be viewed as a positive, rather than a negative.
In such an environment, government bonds would be expected to underperform, as the relative value of the income they yield would look less attractive.
Scott’s view is that building exposure around duration, or interest rate expectations, creates “binary” outcomes, whereas he prefers to build a portfolio of individual bonds, and avoid exposure to any significant theme.
Instead he focuses on valuing a business and understanding whether the value of the business is attractive relative to the price of the bonds.
Fixed income doesn’t have the same portfolio construction benefits as it did in the past couple of decades. Basically 60/40 doesn’t work.
In the current environment, he expects around two-thirds of the returns attained by high-yield bonds to come from the income, and one-third from capital appreciation.
High-yield bond spreads have also been on the mind of David Jane, who runs a range of multi-asset funds at Premier Miton.
He has long had the view that inflation would remain higher than many market participants expected, with the result that he feels most parts of the bond market are likely to produce returns that are correlated with those of equities, defeating the purpose of owning the asset class, he says.
“As such, fixed income doesn’t have the same portfolio construction benefits as it did in the past couple of decades. Basically 60/40 doesn’t work. Duration is no longer the portfolio construction that it has been.
“That said, yields are now considerably higher than a few years ago and despite very narrow spreads, relatively short-dated corporates offer a relatively attractive return, even allowing for some spread widening and higher yields over time. This should at least dilute equity volatility even if it doesn’t go up when equities go down. Hence, we hold a fair amount of dollar and sterling short-dated corporates in both the income, cautious and defensive funds. Much less so in the growth and income fund.”
Scott says the US credit market has underperformed in 2025, and he feels this is justified as “the credit market in the US is generally lower quality”.
Jane disagrees on this point, as he feels the different fiscal and monetary environments mean the US credit market will outperform relative to the UK, but his core view is that while duration has been the primary determinant of the returns achieved from fixed income assets in recent years, this is less likely to be the case in the next part of the market cycle, as the risks are more likely to be idiosyncratic.
Gene Salerno, chief investment officer at SG Kleinwort Hambros, says many investors may have noted that bonds have not performed well during the recent sell-off in US equities and are “disappointed” with the level of return achieved, as they owned bonds to act as a diversifier to their equity exposures.
But his view is that, because the sell-off related to what he regards as overpriced US shares being sold rather than a change in the fundamentals of the economy, bonds were not likely to offer protection, but he still feels they will do so in an environment where there is a material deterioration in economic conditions.
Salerno adds: “So, with that perspective in mind, the role of bonds has not changed a great deal over time. Clearly, the post-GFC period had meant bonds offered less and less yield, but they still offered protection in times of serious threat to economic order.
“You might think of what happened in 2022-23 as a ‘correction’ in bonds – I’d say overdue, but that happened in an environment where the economy proved stronger than many investors/commentators had been expecting.”
David Thorpe is senior investment editor at FT Adviser