The high yield bond market’s performance has benefitted in recent years from the number of clients buying into the asset class with a focus on the income, rather than capital gain, according to Ian Francis, who runs the CQS New City High Yield fund.
Many investors buy bonds in anticipation that the price will rise. In the high yield part of the market, the price of the bonds tends to fall when investors fear a recession is coming, as they wish to reduce the economic sensitivity of their portfolios.
But a feature of the high yield market over the past year has been that, despite interest rates rising, the level of defaults, or companies unable to repay the debt, has been low.
Francis said inflation remaining above central bank target rates, both over the past year and the expectation that it will do so in future, has driven investors whose priority is yield, rather than capital gain, towards high yield bonds.
Investors who own a bond until the date it matures don’t need to worry about the fluctuations in price in between, but the challenge, said Francis, is that most of the companies that issue high yield bonds repay investors’ capital at the end of the term by issuing newer bonds.
Francis said: “Interest rates are going to stay higher [for longer] in the UK, and that means the companies issuing high yield bonds are going have to pay higher coupons, which suits us as income focused bond investors, and suits those investors buying for income.”
If central bank base rates have risen in the years between the bond being issued and being refinanced, then the interest rate the company would have to pay to refinance the debt would be higher.
That increases the risk that some of the high yield bond issuers will not be able to raise the capital to repay investors, and defaults increase.
But Francis believes such companies have been able to refinance due to the presence of investors whose priority is yield.
Nevertheless, he said when buying a high yield bond right now, he does examine the prospects of the company issuing the bond to assess whether it is likely to be able to raise finance in future.
He added that one way in which he does this is to read what equity, and not just bond analysts write about a company, in order to get a wider perspective.
The fund manager said: “We like to look at the worst case scenario when assessing the ability of these companies to refinance.”
Francis said recent economic developments are likely to mean inflation and interest rates are likely to remain elevated, which he believes will boost the income attraction of the asset class, while if rates do start to come down in several years’ time, then he expects the potential for capital appreciation from these types of bonds to increase.
david.thorpe@ft.com