The high yield market also refers to companies, but these lower-quality companies. For instance, if you’ve ever heard of the ‘junk bond’ market, that refers to the high yield market. It’s called high yield because investors demand higher compensation, or a higher yield, because of the additional risk that they’re taking by investing in some of these lower quality companies. Examples of high yield issuers, or the borrowers of money in the UK market are Pizza Express and Tesco. Because these companies are riskier, they’re generally not able to borrow money for as long a period of time as you’d see in the investment grade corporate bond market. So the average maturity of the high yield market is around 6 years, which is shorter than that of the investment grade bond market.
The main risk in high yield is the risk of default, or in other words, that the company does not pay you back, either through the periodic coupon payments or the final par value at the end of the bond’s maturity. As default rates move up, you will see spreads (the difference in yield between e.g. a corporate bond and a relevant government bond) widen to compensate investors for this increased amount of risk. But if we look at the market right now, as you can see in the chart below, current default rates are very low, at around 2%, which is significantly below the long-term average of around 3.7% (as at November 2018).
What you will see is that in periods of stress, that default rate will spike up, so for instance during the dotcom bubble in the early 2000s, or during the global financial crisis in 2008/ 2009. Admittedly, default rates are a ‘backward-looking indicator’: what I mean by that is that by the time a company has defaulted and failed to pay back their debt payments, the prices of its bonds will have already dropped significantly to reflect this increased risk. So one of the indicators that we look at to give us a forward-looking view of the health of these companies is, what are they doing with the money that they borrow?
As bond investors, we think of ourselves as lenders of our clients’ money. So we take our clients’ money and we lend it out to countries and to companies, and we want to make sure that they can pay us back with interest. And what are they doing with that money that we lend to them?
In the high yield market today, currently about two thirds of the money these companies are borrowing is actually going towards refinancing, so essentially refinancing their old debt at lower yields. This is considered a very conservative use of capital - it shows that companies are not being overly aggressive or over-leveraging their balance sheets. So this is a reason why we remain comfortable and positive on the high yield market today.
Another interesting factor in the high yield market right now (November 2018) is the difference between the US and Europe, from a valuations perspective, or in other words where the two markets are trading, and the spreads and yields that they are offering. Typically what you see is that the European high yield market will trade at a lower spread to the US high yield market. And that’s because in general, these companies tend to be higher credit quality, even though they’re still in the high yield space, and they also tend to have lower maturities, so again, investors don’t need to be compensated as much because they are not lending out their money for as long a period of time.
However, we’ve seen this relationship shift: so actually right now, European high yield spreads are around 4.6%, whereas US high yield spreads are at 4.25% (as at November 2018). So Europe is trading wider than the US, partly for two reasons: one is that some weaker macroeconomic data in Europe, as well as some political instability in various countries across Europe, for instance in Italy. We view this as an investment opportunity, given that European high yield spreads are typically not wider than the US.
The value of your investments and the income from them may go down as well as up and neither is guaranteed. Investors could get back less than they invested. Past performance is not a reliable indicator of future results. Changes in exchange rates may have an adverse effect on the value of an investment. Changes in interest rates may also impact the value of fixed income investments. The value of your investment may be impacted if the issuers of underlying fixed income holdings default, or market perceptions of their credit risk change. There are additional risks associated with investments in emerging or developing markets. The information in this document does not constitute advice or a recommendation and investment decisions should not be made on the basis of it.
