High yield bonds brave autumn storm in equity markets
While high yield bonds also weakened during the recent equity market correction in October, they performed relatively well compared to other asset classes, particularly equities. Their lower sensitivity to interest rate movements and their carry provided a safety buffer against the volatility. Peter Jeggli, senior portfolio manager at Fisch Asset Management in Zurich, believes the late phase of the economic cycle still offers opportunities in high yield bonds, and is focused on bonds backed by strong fundamentals.
“High yield bonds withstood relatively well the autumn storm in financial markets. They therefore showed the behaviour that investors expect from this asset class in a scenario of rising interest rates and correcting equity markets", says Peter Jeggli.
Within the fixed-income universe, high yield bonds have been among the best performers so far this year and are benefiting from the strong macroeconomic environment. "This environment is likely to continue for the time being. The default rate of only around 2% in the US, which is well below the historical average of 4%, is supportive. Although we continue to expect heightened volatility, as an active manager we see this as an opportunity to exploit inefficiencies in the market. For example, our buy list now contains good quality borrowers with liquid bonds, which were indiscriminately punished in adverse market conditions like those we have just experienced”, Jeggli remarks.
The fund manager currently favours a defensive approach. This means keeping an eye on the recovery rate, i.e. the amount the investor is expected to recover if the bond defaults. "There are huge differences between issuers' business models. The assets that could be used to pay investors therefore need to be analysed carefully. In this part of the market cycle we concentrate on adding companies with strong fundamentals to the portfolio, in order to maximise downside protection. Although official ratings indicate the probability of default, they say little about the level of compensation the investor will receive if default occurs. Both sides of the coin are important for us", says Jeggli.
The fund manager is particularly attracted to ‘fallen angels’ – companies that have lost their investment grade rating, and whose bonds come under considerable pressure as a result. Many investors are forced to sell these bonds, as they are not permitted to invest in the high yield segment. These forced sales can often push the bond price below its ‘fair’ value. Jeggli gives a recent example: "The British supermarket giant Tesco was downgraded to BB three years ago. As we believed the company was likely to survive, we thought the bonds represented a good opportunity. Now in October one of the rating agencies upgraded Tesco to investment grade and our investment paid off handsomely. This example demonstrates there can be opportunities even in a challenging sector like retail. Every decision will certainly not be successful, but it shows the advantages of active management compared to passive ETFs. Through active management investors can benefit from inefficiencies such as fallen angels. We believe high yield bonds remain a worthwhile and attractive alternative within the bond world and that long-term investors should consider an allocation to them."